Automated Trading: What It Is, How It Works, Pros and Cons

Automated trading has become widespread, accounting for 60-73% of all US equity trades. In this article, we’ll explore why automated trading is so popular and how to avoid common pitfalls in trading codes.

Automated trading (also called “algorithmic trading”) involves using a computer program to place trades; the program is given rules for when to enter and exit positions and what position size to trade. Successful automated traders are skilled in both programming and developing and testing trading strategies.

In this article, I’ll show you examples of automated trading systems and explain how they vary from discretionary trading systems. I’ll also discuss the pros and cons of algorithmic trading versus traditional trading.

What is Automated Trading?

Automated trading involves creating trading strategies for financial markets that are based on specific rules. Generating and coding those rules can be simple or difficult, depending on the complexity of the strategy.

Automated trades must be planned according to simple rules and parameters that a computer can understand. For example, a simple automated strategy could specify to buy 100 shares of stock when the daily closing price moves above the 100-day moving average.

That means the program would automatically sell the 100 shares when the stock crosses below and has a daily close below the 100-day moving average.

The more complex the system, the harder it will be to code all the rules. For example, human traders can identify a triangle chart pattern quite quickly. You could then tell a human to buy when the price moves above the triangle. A computer, on the other hand, doesn’t know what a triangle looks like unless you tell it via rules.

To automate a triangle trading system, you would need to tell it how far the price moves (uptrend or downtrend), what that move looks like, and on what time frame, before the triangle forms. Then you would need to specify that price waves are getting smaller which creates the triangle-like appearance.

Then there also needs to be time or lookback constraints so that the computer knows to only look for chart patterns over the last one month, for example — and not over the last decade. There is nothing wrong with developing more complex programs, but the coding skill required increases.

The coded program is then linked to a broker so that the computer can execute trades through the broker, similarly to what a person would do.

Connecting software to a broker is easily done through most trading automated trading platforms, including MetaTrader 4, ThinkorSwim, NinjaTrader, TradingView, and many others. In most cases, you can code right in the platform, and then execute the program so that it trades your account.

How Automated Trading Works

A key component of automated trading is including all the variables and considering as many contingencies are possible when coding a strategy. There are many things you understand and take for granted that a computer doesn’t know to look for.

Here are some of things you will want to consider when trading an automated system. This is by no means an exhaustive list, but hopefully it will help you fill in some holes in your system if you decide to code one.

• What is the precise event that tells the computer to enter a trade at a specific moment, and only that movement?
• What is the precise event that tells the computer to exit a trade?
• What order types will be used? Market, limit, stop, stop limit, or other?
• What market will the program trade? Are there things it should or shouldn’t trade?
• How is position size determined? Will it be via a percentage of the account or a fixed dollar or share amount?
• How is risk controlled? Is a stop loss deployed? Where is it placed?
• Will your program trade through major news events? There are often extreme volatility and large spreads during such times. You could program rules to either stop trading and exit trades before news, or to capitalize on news.
• Will the program run all day or night, or will it only run during certain hours of the day?
• What is the price input for the algorithm? Can it trade each tick? Only at the close of a price bar (1, 5, 15-minute, etc.)? Or a combination of these?
• How are price moves measured? From swing low to swing high? How are swing highs and lows determined (zigzag indicator may help)?

There is also automated trading software available that allows you to create a program with a list of variables. For example, you pick your asset, time frame, technical indicators, entry method, exit method, position sizing method, and so on. The software compiles this into a code that you can test on historical data to see if it is viable.

You can update and tweak the parameters until they are acceptable to you. These programs are often called Wizards. Keep in mind that Wizards may not include all the variables you need to consider (such as how the algorithm handles trading around news, for example).

There is also the option to manually turn your automated strategy on and off when you want it to trade and when you don’t. This can sometimes save some coding time.

Pros and Cons of Automated Trading

Is manual trading better than automated, or the other way around? Let’s look at the pros and cons of algorithmic trading.

There are several things that make automated trading an attractive option for traders:

• The program doesn’t have emotions. If it is programmed well, you can let it run without your own emotions interfering — or that’s the idea, anyway. Many people still get stressed over their algorithm’s performance, and may change the code or turn it off or on when they aren’t supposed to. So emotions still play a role.
• You can test the rules for profitability since the rules are well-defined. An automated strategy either works or it doesn’t. Since there is no discretion, the rules produce a profit or they don’t. You can keep tweaking the rules until they do.
• Computers are much faster at executing orders than humans are. This can be an advantage.
• You can program algorithms for different things, essentially doing the jobs of multiple humans. For example, you could have algorithms trading multiple markets at the same time.

But automated trading isn’t without its downfalls. Here are some disadvantages of automating your trades:

• It isn’t hands-off. Things can change in the market, so you need to understand your automated trading strategy and continuously monitor its performance.
• If something goes wrong with your software or algorithm, it could mean big losses if it keeps running, you can’t turn it off, or you forgot to program certain variables.
• Over-optimization can happen — this is when you tweak a system so much on historical data that it is unlikely to work in the future. In that case, it is too specifically calibrated to the data it was tested on. Since most traders want the biggest profits possible, over-optimization is a very common problem.
• Automated traders need to be able to code and develop trading strategies. These are separate skills, each taking time to learn. Simply learning to manually trade (and not learning coding) is a quicker path to trading success.

Automated Trading Isn’t a Get-Rich-Quick Scheme

There are loads of scams related to automated trading and “trading robots.” Be careful of these!

Nearly all robots and “expert advisors” you see being sold online for a few hundred or few thousand dollars won’t be around a year from now. Your money will vanish, and likely the robot will have also lost all your money in your account.

Why? Because of over-optimization. People build robots, backtest it, and get it to produce fantastic results on past price data. The robot is then sold as a way for you to make quick money. The problem is that it typically doesn’t work on live, real-time market data. The only person making quick money is the robot-seller.

Beware anything that promises great returns with little work. Remember, it is not only the upfront cost of the robot you are paying for. If you give it access to your trading account, it could do much greater damage there.