Understanding the Forex Trading Algorithm – Profit & Risks
Algorithm trading is the process of carrying out commands based on automated trading instructions where the variables taken into consideration are time, price, and volume. The speed and efficiencies of computing resources of sophisticated systems are used to leverage trades instead of depending on human abilities and proficiencies.
Since the early twenty-first century, algorithm trading has witnessed exponential growth, retail and institutional traders, pension funds, hedge funds, investment banks, and mutual funds as trading volumes and performance became too large for human traders to react to. As of 2016, 80 percent of the Forex trading market was done through trading algorithms instead of human intervention. Algorithmic trading is automated trading that utilizes various strategies for trades. These are dependent on mathematical finance and formulas and rely on specialized software for execution.
Algorithmic FX Trading | Profit & Risk
Forex Capital Markets FXCM
One of the early pioneers and developers of the electronic trading platform, a derivative of the modern algorithmic trading systems, was Forex Capital Markets – FXCM – for trading on the foreign exchange market. In the formative years, in 1999, in New York, FXCM was called the Shalish Capital Markets but was rebranded to FXCM a year later. In 2003, FXCM expanded overseas when an office was opened in London under the regulation of the UK Financial Services Authority.
However, FXCM became a victim of circumstances when in January 2003, it partnered with the Refco group of the USA, one of the largest futures brokers in the country. The FXCM software was licensed by Refco for use by its clients. A 35% stake in FXCM was obtained. In 2005, Refco filed for bankruptcy after the fraud was detected.
FXCM, thereafter, faced turbulent times. In 2015, it was in breach of regulatory requirements. In January, FXCM was forced to announce that it forgave 90% of accounts that had negative balances due to large-scale price movements of the Swiss franc. In 2017, FXCM was fined for fraudulent activities. FXCM was subsequently barred from the CFTC and the NFA. In response, FXCM changed the name to Global Brokerage. The real interest of Global in FXCM was 10 to 50 percent, depending on the distribution of FXCM. In February, FXCM rebranded again, and as of March 2018, FXCM is the second-largest Forex broker outside Japan. FXCM remains the pioneering spirit behind Forex algorithmic trading today.
An Overview of Forex Algorithmic Trading
About three decades back, the Forex market conducted trades over the telephone and centered on institutional investors, unclear price information, a clear demarcation between deal-customer and interdealer trading, and negligible market forces.
Today, thanks to technological innovations and cutting-edge systems, the Forex market has taken a quantum leap into the future. Trades are made fast over the market, while the transparency of price movement is assured due to the real-time streaming of the latest currency values. The fine dividing line between dealers and customers is now minimal.
The Forex scenario turned for the better with the introduction of algorithmic trading. But while it has increased trading speed and accuracy, it also poses certain risks with the set-it and forget-it trading, which will be elaborated later in this article.
In the Forex markets, trading in currency pairs occurs as per quoted prices in varying volumes, and a base currency is attached with a value in terms of another quote currency in the pair.
Forex is the world’s most liquid and largest financial market and operates around the clock five days every week. The global average daily volume of Forex trading was about $6.6 trillion in April 2019, of which the bulk was in USD, Euro, and Japanese Yen. While speculative trading is one of its main reasons, people have to trade in currencies to buy foreign goods and financial services both in the long and the short term. Hence the trading experience in Forex affects real exchange rates and can seriously influence any particular nation’s economies. This is why all sectors, ranging from policy-makers to investors to financial services providers, are interested in the Forex markets.
Algorithm Trading in Forex
The rise of Forex trading is largely attributed to algorithms automating certain Forex processes, thereby lowering the time taken for transactions to go through. The rise of efficiencies due to automation has resulted in reduced costs and time for executing the processes. Banks dealing in Forex and financial instruments use the opportunities offered by algorithms to update prices of currency pairs on their electronic trading platforms. Hence banks are well-placed to increase the speed of quoting market prices while significantly doing away with the tedious manual processes.
There is another advantage for banks, too, programming algorithms to reduce exposure to risks. The algorithms are used to sell a specific currency that matches a customer’s trade purchased by the bank to maintain the volume of the same currency. Banks can, therefore, use algo trading and an optimized trading strategy to maintain risk exposure at constant levels against that currency.
In the financial markets, there are primarily four types of algorithmic trading.
- Direct Market Access – Here, algorithmic traders connect to and access multiple trading platforms at low costs but very high speeds.
- Auto Hedging – This is a strategy where rules are generated that reduce any high level of risk of the traders.
- Statistical – This is a highly optimized algorithm strategy that analyzes a series of historical trading data statistically to arrive at a profitable trading opportunity in the present.
- Algorithm Execution – In this strategy, the goal is to carry out a pre-fixed goal like executing a quick trade or reduce the market impact.
An offshoot of algorithm trading is high-frequency trading, a high speed, and the rate of trade order execution. It offers significant opportunities to traders to make trades within milliseconds of market price changes, enabling traders to a high level of risk when trading in Forex.
Algo trading is also the driving force in speculative Forex trading. By combining high-frequency trading and the possibility to quickly analyze data and execute orders in a trading strategy in currency pairs, retail traders can buy or sell and exploit arbitrage opportunities that arise even in the smallest of price differences in currency pairs.
The Forex markets are mainly based on hedging trades through spot options and currency options. The spot market, which is the buy or sell of foreign currency for immediate delivery, has grown rapidly after algo trading platforms were introduced in the 2000s. In the case of Triangular arbitrage, which is the process of converting a particular currency back to itself after going through a range of currencies, the identification of precise algorithmic and high-frequency trading can only be made through automated algo trading programs.
FX trading system has benefitted hugely by algorithms as it helps to find popular searches trading trade quickly and efficiently, provide accurate market insights, and lower transaction costs. As a derivative, Forex options operate similarly to options of other securities. The trading strategy adopted by retail traders is often also the same. The foreign currency options give retail traders the right to trade on a trading platform at a particular exchange rate in the future. Automated algo trading and computer programs have binary options as an alternative for hedging foreign currency transactions. In binary options, there are two possibilities – trade completes either at zero or a pre-fixed strike price.
Algorithm Trading in the Forex Market
Much of the rise in the programming language and the trading software of algorithmic trading strategy over the past few years has resulted from automating certain processes and lowering the hours required to carry out foreign exchange transactions. Operation costs too for processes like the execution of trade orders are lowered, and hence implementing an algorithm trading strategy is a better option than the manual route. Banks have also implemented electronic processes in their trade operations, and the algorithms are programmed to update the prices of currency pairs. It helps banks to quote market prices instantly while cutting back on man-hours.
Here are some of the algorithmic trading strategies followed to maximize returns and cut down high-risk exposure.
- Trend Following – This is the simplest of trading strategies that guarantee the maximum return of investment and money. It means following the market trends of the investment world with buy or sell orders generated from a fixed set of conditions that are met by select technical indicators. The algorithmic trading strategies of FX trading based on this principle compare historical and current data to predict the execution of trades and whether the current trends will reverse or continue.
- Mean Reversion – Another form of an algorithmic trading system is the mean reversion system. Reversion assumes that about 80 percent of the time, the markets are ranging. This strategy is employed by the black box trading to estimate an average asset price through historical data and accepts trades in anticipation that the current price will revert to the average price.
- Market Sentiment – Commercial and non-commercial positioning is used to decide market highs and lows. FX trading algo strategies are founded on market sentiment and use a COT report or a system that can find out extreme long or short positions. In the modern digital environment, it is also possible to scan social media networks to understand currency bases.
- News-based Algorithm – This is commonly known as trading the news and is an algorithmic trading system that is news-based and linked to news wires. The trading experience is enhanced as the market participants automatically generate trade signals based on the average price and how the real data will be compared to historical data and market consensus.
- High-Frequency Trading – This one strategy, as the name denotes, is known for the execution of trades at lightning speeds, going through buy and sell orders, and closure of trades in milliseconds. The strategy is based on optimizing quick price fluctuations and using arbitrage and scalping in high trading volumes to limit orders and trade quickly.
- Arbitrage – Arbitrage is when traders take advantage of the price difference in two or more markets. A combination of deals is set up in currency pairs in different markets, and the variation in one market against another is what brings in the money and profits. Arbitrage is characterized by zero negative cash flow at any one temporal state and positive cash flow in another. For example, this will happen when the price, say on the New York Stock Exchange, gets ahead or behind on the Dow Jones Industrial Average.
How is arbitrage linked to algorithmic trading software? It means that the trading operations systems look for price imbalances across various markets and make money from them. It is necessary, of course, to trade in huge volumes to make profits as the Forex price differences are in micro-pips. Triangular arbitrage, which also falls under this head, is where traders deal in two currency pairs along with a currency cross between the two.
- Iceberging – This strategy is preferred by large financial institutions that prefer to keep their Forex algorithmic trading strategies close to the chest. This one may not be suitable for all investors, especially retail investors. Rather than place one huge short or long position, the trades are divided into small positions and execution done through different brokers. The algorithm trading platform can also place these orders at various times so that other investors cannot find out. The advantage here is that leading brokers can work under normal market conditions without triggering massive price fluctuations, and retail traders can only see the “tip of the iceberg.”
- Stealth – This is on the same lines as Iceberg but goes a step higher in the trade concealment field. This, too, may not be suitable for small trading investors. Iceberging has become so common that hardcore market watchers can piece together the smaller orders by hacking into the algorithmic trading strategy and figuring out the large market player behind the trading.
Developers of algorithm trading software have a high level of expertise and knowledge in computer programming and financial market analysis. Quantitative analysts and professionals have to be trained in C++, C#, or Java programming before creating top-of-the-line algorithmic trading programs.
Is Forex Algorithmic Trading Profitable?
It is seen that there are various algorithm trading strategies but do they bring in the money and the profits? What if algorithm trading was not there? Would Forex trading be as lucrative and rewarding as it is now? The answer is a NO because algorithm trading has taken Forex trading to an altogether different plane. Let us consider the different aspects of Forex trade execution and pairs trading against manual mode and computer programs.
Forex trading is mostly about keenly following indicators for signals and then undertaking trades based on those signals. When starting, beginners have to note down all the trades in a trading journal, and as they gain experience should be able to identify the method and setup that has made the most money. Now think of a scenario where a computer program automatically identifies all the setups and trades and leaves the investors free of the burden of the charts. This is the advantage of the algorithmic trading systems that enables more trading and more profitability.
The amount of financial data to be dealt with in trading in Forex is astounding. Price feeds are streamed live from the exchanges through an application interface, and analyzing and understanding all these numbers and deciding on the ideal currency pair to deal with in multiple exchanges is not an easy task. Fortunately, computers work faster than the human brain when it comes to math and dissecting numbers. Hence you get ahead of the game through an automated program, which is what algorithmic trading is all about.
For getting good returns on investments in Forex markets trading, the key is the technical analysis in the study of charts. Market conditions are determined by studying patterns and using indicators, which are mathematical functions of the price and volume of assets.
So what does it ultimately mean? Apart from an excellent understanding of quotes, knowledge, and trading strategies, it all boils down to a numerical analysis of math problems. Here, algorithmic trading systems come out on top as computers are way faster and more accurate in this aspect. Hence, it is surely preferable to let the computer do all the spotting of favorable Forex trades and work for you.
The algorithmic trading strategy is purely technical. Let’s see how it works. You identify a setup that works for you (generally suitable for all investors) and decide what to do with it. The option includes placing a buy order with a stop loss below the last support level and closing the trade. The execution might appear very simple, but it is fully numerical with paperwork. However, once you use algorithmic trading software for trading activities, these same parameters can be fed into the computer for better analysis and processing and quicker and higher profits.
The advantage becomes clearer if a more advanced example is to be considered. Take the case where you want to combine, say 5 indicators and instruments trading baskets of 7 different assets. This volume of information is not easy for a human mind to handle even if you have a lot of education in the Forex field. You have to be glued to your screen, waiting for the indicators to pop up green so that you can enter the market. You can also make a mistake in trading strategies since your attention is divided among various markets.
This is where optimized algorithm trading strategies can come to your help and assist you in making sense out of all the figures to book profits. A computer can carry out almost unlimited trade execution and handle more multiple assets and indicators than humans.
Admittedly, computers do have their limits, but even with a basic laptop, it is possible to undertake algorithmic trading strategies that will ensure not only fast and accurate data analysis but also profitable algorithmic trading in Forex.
Risk Factor Involved in Forex Algorithmic Trading
While algorithm trading strategies help traders make profits and leave all the work to the computers, there is a flip side that threatens the liquidity and stability of Forex trades.
One of them is related to the skewed trading power of the participants. Some trade with the most sophisticated computing power, which executes trades and obtains the information faster than the others. This imbalance within the trading algorithmic scenario could lead to a liquidity crisis and fragmentation within the markets.
Even though it is known that Forex and stock market expertise and education are fundamentally different, there is a strong perception that high-frequency trading, as seen in types of algorithmic strategies, could lead to a flash crash in Forex markets as happened in the stock market crash of May 6, 2010. The drawback is that algorithms are programmed for specific market situations and might not respond immediately if drastic changes occur.
The way out if such a calamity in algorithmic trading is ever foreseen is to suspend trades during the period of turbulence. But on the other hand, if climate algorithmic trading is to be suspended in hostile trading, the multitude of participants within the system could result in a heavy reduction in market liquidity and high volatility.
While algorithmic trading is done at lightning speeds, it also means that even one glitch in an algorithm can pile up millions in losses in a brief period of time. An example of a disastrous faulty algorithm is that of Knight Capital that lost close to $440 million in 45 minutes on August 1, 2012. A recently-introduced algorithm made millions of faulty trades by buying stocks at high “ask” price and selling them at a low “bid” price, instead of the opposite as it should be. Such a possibility in Forex algorithmic trading cannot be ruled out.
The exponential growth in Forex can be attributed to trading algorithms. Banks and large financial investors dealing in Forex have automated their processes through algorithmic trading strategies that have increased efficiencies and profitability. In their table of contents for algorithmic trading, dealers have pension funds, hedge funds, mutual funds, Forex, bonds and stocks, and more.
Banks use algorithmic trading in Forex to update the price of pairs of currencies on their electronic platform for trading, which increases the speed of quoting market prices and lowering costs.
Following optimized algorithmic trading strategies also helps to maintain risk exposure at constant levels against that currency.
While there is a positive side to algorithmic trading, there are risks involved too. A glitch in the high-speed trading algorithms can have disastrous consequences on the whole system.
1) Is Algo Trading Profitable?
Ans: In Forex trading, participants follow indicators for signals and then undertake trades based on those signals. In manual mode, trades have to be noted in a trading journal. Now, when algorithmic trading strategies are implemented, a computer program identifies all the setups and trades automatically and leaves the investors free of the burden of the charts. This is the advantage of the algorithmic trading systems that enables more trading and more profitability.
2) What Is a Forex Algorithm?
Ans: Algo trading is also the driving force in speculative Forex. By combining high-frequency trading and the possibility to quickly analyze data and execute orders in a trading strategy in pairs of currency, retail traders can buy or sell and exploit arbitrage opportunities that arise even in the smallest of price differences in the markets.
3) How Do You Create a Forex Algorithm?
Ans: The first step to create an algorithm is to find a winning strategy on which it will be built. For instance, you can opt for a strategy based on moving averages. After the strategy is finalized, it is profitable and shows high odds of being a success; it has to be translated into an algorithm. The third and most critical part is to back-test the algorithm. Most platforms in the markets offer the chance to test algorithms against historical price action.
4) How Much of the Market Is Algorithmic Trading?
Ans: In 2016, 80 percent of the trading market in FX was done through trading algorithms instead of by human intervention. Algorithmic trading is automated trading that utilizes various strategies. These are dependent on mathematical finance and formulas and rely on specialized software for execution.