Founded in mathematics and computer science, an algorithm is a set of instructions that are to be performed. An easy example would be a recipe or building plan, where you start with the ingredients/materials and the step-by-step instructions, which ultimately ends in a finished product.
In today’s day and age, we have harnessed the immense computing power at our fingertips to perform these tasks. Given the complexities of the stock market, algorithms have been implemented to aid in trading.
Below, we detail some of the more common algorithm trading strategies. The first four are high- frequency trading algorithms, while the last two are execution algorithms.
- Trend Following: This is the most common algorithm trading strategy and involves making decisions when a security’s moving average crosses a predetermined threshold.
- Arbitrage Opportunities: Arbitrage is the act of buying a security at a lower price and immediately delivering that security for a higher price. While markets are thought to be efficient, pricing discrepancies do exist in the market from time to time.
- Index Fund Rebalancing: Index funds have a hard rebalance date to bring the portfolio back in line, and with an algorithm strategy, some traders are able to take advantage of this opportunity.
- Trading Range: This strategy relies on the reversion to the mean, and thus when a security’s price is either too high or too low the security is purchased or sold.
- Volume-Weighted Average Price (VWAP): VWAP is used to break up a large order into many small orders so that the average executed price is as close to the volume-weighted average price as possible.
- Percentage of Volume: This strategy aims to be a certain percentage of the volume until the full order is filled.
Large institutional investors are most likely to use algorithmic trading given that they are typically trying to buy a large quantity of shares at the best possible price. Because the complexity of the market has changed over time, it helps to understand some aspects that could impact the market.
