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A common dilemma for FX traders is whether to adopt a manual or algorithmic trading strategy that produces profitable outcomes over the long-term. The last few decades have seen an inexorable increase in the amount of algorithmic trading. These pre-programmed trading strategies were historically only feasible for hedge funds and other institutional investors. In this special supplement we look at the growing importance of algorithmic trading and the role it plays in the markets.
Algorithmic trading uses a pre-programmed set of rules to systematically scan the markets looking for portfolio picks. This type of approach is most closely associated with hedge funds, where the idea is the automated trading will enable them to make money in all market conditions. Charalambos Psimolophitis, chief executive officer (CEO) of FxPro, says these algorithms are sometimes referred to as Expert Advisors, or EAs for short. Algorithmic trading is now an essential technique for controlling risk and reducing transaction costs. The most common example sounds pretty mundane, but it saves a great deal of money by reducing the day-to-day cost of trading significant volumes of securities. Some algorithms only generate occasional trades whereas others utilise a technique known as high-frequency trading (HFT).
HFT strategies analyse the electronic data and instigate orders on the back of it far faster than any human trader would be able to respond.
In 2010 an automated trading algorithm was responsible for the so-called flash crash where America’s headline Dow Jones Industrials index lost 1,000 points in a matter of minutes only to then bounce straight back. The regulators responded by bringing in circuit breakers that would temporarily shut down trading should a similar pattern emerge in the future. Forex trades are highly leveraged and in an area characterised by considerable underlying volatility there should be lots of potential opportunities to exploit.
The basic idea is you use a computer program to analyse the forex markets to identify trades. A simpler option is to download a ready-made algorithm put together by a successful trader or market guru.
The design of these algorithms is now so important there is an annual automated trader competition with large cash prizes where anyone can put their EAs to the test. FxPro’s in-house research shows that, on average, clients who use an algorithmic trading system enjoy results that are five times better and more stable than those who trade manually.
According to Psimolophitis, an analysis of FxPro client trades conducted during the past three and a half years shows the percentage of EA winning trades per month is statistically higher than the manual trade wins per month. This may be partly due to how EAs limit some of the behavioural biases, as when using an algorithm you are not tempted to sell winners too soon or hold onto losers for too long in the hope the positions will turn round. Expert Advisors can be switched on and off at any time in order to prevent the EA from opening certain trades during periods when extreme volatility is expected, such as during economic announcements or market openings. Psimolophitis says the FxPro Quant Strategy Builder enables users with no programming experience to easily create an Expert Advisor that will carry out the trading strategy they desire. FxPro uses what is known as the Agency Model, whereby client trades are sent straight through to a pool of leading liquidity providers.

Josh Raymond, chief market strategist at City Index, says auto trading means you can trade the markets within the parameters of a specific strategy at all times of the trading day, regardless of whether you are watching market prices or not. For example, you could be asleep whilst the markets are open in Asia and if the dollar-yen trades within a specific pattern or trend that you have defined in your trading strategy, the system will trade it for you automatically. To implement one of these strategies you simply have to open the chart for the market you want to trade and select the trading system you want to apply. One way of doing it is to use Trader Connect, a social tool developed by Alpari that enables clients to talk directly to each other and swap EAs. The dream of all traders would be to design an infallible ‘black box’ that relentlessly makes money, but in reality there is no such thing.
Despite this there is plenty of evidence that systematic trading strategies can produce better returns. Traditionally, the only way in which investors have been able to benefit from algorithmic trading strategies is via a hedge fund. You do not have to be a high net worth individual to benefit from algorithmic trading as there are some decent systematic options available to private investors.
The majority of the algorithmic funds available to retail investors tend to use trend-following strategies. Mick Gilligan, head of research at Killik & Co, says most trend-following funds target medium-term movements because the transaction costs would be too high to trade shorter-term ones.
Winton trades a wide range of futures and forwards contracts on all major, liquid asset classes, in equities, bonds, interest rates, forex and commodities. The company uses statistical research to develop proprietary trading systems for the international markets. The fund tracks an index that is designed to capture the performance of the Winton Trading Strategy, a trend-following algorithm based on the Winton Diversified Program.
But this question requires an individual to really understand their own capabilities when it comes to making decisions in high-pressure trades; and to recognize how technology can help overcome limiting psychological habits. Substantial trading experience and a deep knowledge of the FX markets are huge positives when it comes to forming profitable trading strategies and should never be discounted in favour of algorithmic technology.
FX traders can become influenced by the most recent trading results, without considering the bigger picture. Advances in technology now mean that similar facilities are available to private individuals, most notably those who trade foreign exchange (forex). We then focus in particular on forex and the algorithms you can try for yourself, before assessing the systematic hedge funds and the regulated versions available to retail investors.
A lot of hedge funds use trend following algorithms or macroeconomic models that are based on an analysis of the historical time series data. Advances in technology now make it possible for individual investors to try algorithmic trading for themselves. If an institutional investor enters a large order it could tempt traders in on the other side of the book to try to take advantage of a potentially favourable fill. These can involve thousands of transactions a second, with the underlying technology able to process each trade in a few hundredths of a microsecond. It is thought that a large sell order prompted high frequency traders to drive down the price of the futures contracts at the same time as it forced liquidity providers and market makers to withdraw from individual stocks.

If you want you can leave your algorithm running from Sunday night through to Friday evening, as it should always be able to trade in and out of the markets without any form of overnight risk. Trades are based on price extremes as indicated by Bollinger Bands and on momentum, as measured by the RSI and the Stochastic Oscillator,’ says Psimolophitis. Most of these algorithms will take as input parameters stop loss and take profit pips, volume per trade, and percentage risk per trade, with traders generally able to alter these based on their risk profile and expectations,’ explains Psimolophitis. It has over 100 built-in trading strategies and those who want to can also construct and back-test their own using the Advantage Trader scripting language.
James Hughes, the company’s chief market analyst, says a high percentage of the currency trades Alpari UK handles are instigated by some form of automated trading algorithm.
It is similar to a Twitter engine as once you are logged in you can see how the others are getting on, which might help you to confirm your own algorithm is doing what you want it to. Markets change and an algorithm that works for a while can quickly lose the Midas touch, which is why you need to keep a close watch on the results and be quick to pull the plug if it stops working. There is often a distinct lack of transparency about their trading processes and limited liquidity, with some vehicles offering clients a chance to get in or out just once or twice a month.
It is our favoured option as investors can trade in and out of it whenever they want and there is the extra layer of corporate governance that comes from investing via a separate feeder fund,’ says Gilligan. Its software is designed to identify trends ahead of other equivalent algorithms, which allows it to target shorter-term trends than would otherwise be possible.
These mathematical algorithms are derived from the historic data but are continuously evolving and designed to deliver long-term returns in a whole range of different market conditions. Consider if a trader’s most recent trade loses, after a particularly pleasing run of results.
It is particularly common in the currency markets where a large volumes of private client trades are instigated on an automated basis. Some firms have incorporated the functionality within their in-house trading platform, whereas others give clients the option of using MetaTrader 4 (MT4), a third-party software package specifically designed to trade the currency markets. All pending client orders to open or close trades are kept on the company’s servers until triggered, at which point they are sent to the market to be implemented.
This means the experienced trader will have managed enough trades to know the dangers of acting on blind patterns and gut instinct, while knowing to avoid trading at times when the markets are particularly volatile.
As soon as the visible part is executed the algorithm promotes another tranche to take its place. But even experience is prone to human error - and this is the negative side to solely placing trust in a manual trading strategy.
Despite these psychological mine fields, if FX traders take the time to watch their own psychological traits, it can lead to a dramatic improvement in the ability to make a manual trading approach successful.
But these losses can cause traders to doubt their approach and whether they can generate consistent profits from the market anymore. Self-doubt leads to rushed and costly decisions, and this is real danger of manual trading.

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29.10.2014 | Author: admin

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