Algorithmic Trading in Forex | Learn or Pass?

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Algorithmic trading, which has a meaning closely related to automated trading is something any trader should know about. Nearly 30 years ago, the Forex market was characterized by trading over the phone, institutional investors, ambiguous price information, a clear distinction between traders and seller-client transactions, and low market concentration. Today, trades can be executed quickly from a computer, allowing retail traders to enter the market. 

Another significant change is algorithmic trading systems, which may have improved the performance of forex investing. However, they also come with risks. In this blog post, we will identify some of the benefits of algorithmic trading for currency trading, examine the fundamentals of the forex market and algorithmic trading, and highlight some of its inherent risks.

What is Algorithmic Trading?

Algorithmic trading is a type of trading in which computers trade in the financial markets instead of humans. In this type of trading, a powerful processing system makes all the necessary decisions to enter a position, manage capital, place orders, monitor the market, and so on, based on the type of trade it has been coded for. 

It is worth noting that robot traders are a subset of algorithmic trading, which means that algorithmic trading covers a larger area. Trading algorithms are not only used to make profits in the market; some companies use them to monitor the market, manage capital, and reduce trading risk.

Forex VPS can help improve the efficiency and performance of algorithmic trading as it provides a stable and low-latency environment. But before, you should know what is a Forex VPS if you don’t.

What are the functions of algorithmic trading?

• Market monitoring and finding trading opportunities
• Positioning and placing orders
• Management of open positions and determining profit and loss
• Risk and investment management

How Algorithmic Trading Works in Forex 

An algorithm is simply a sequence of instructions that a computer uses to do a transaction.  These guidelines help forex traders decide whether to buy or sell currencies based on factors such as price, timing, and volume. The computer follows the rules based on statistics and prior data so they can predict possible price movements. These rule sets are typically termed "expert advisors" or "Forex trading bots”. Algorithmic trading strategies for Forex can be a good option as computers don’t have emotions so the trading will be more logical and less impulsive. For example, you can instruct the computer to buy a currency at one price and sell it at another, utilizing simple price movements or more complicated elements such as historical trends and news. The best this is that Forex traders can run multiple algorithms at the same time, and handle multiple deals across different accounts. As a result, they can increase market coverage and trading efficiency.

Types of Algorithmic Trading Strategies in Forex

There are many trading strategies for algorithmic trading in Forex, which are installed by programmers in the Forex trading robot. Below are the important algorithmic trading strategies:

VWAP Strategy

Volume Weighted Average Price Strategy, which is the average price paid for an asset that is weighted by volume. The VWAP strategy distributes the volume of orders evenly over a given period at the best bid or ask price but does not exceed the weighted average of the volume price over that period.

TWAP Strategy

Time Weighted Average Price Strategy, which is the average price weighted by time (the average price of securities at a given time). The TWAP strategy executes orders and divides them evenly into equal time intervals. TWAP does not account for expected trading volume changes that may impact the market.

Volume-based Trading Strategy

This strategy supports a fixed percentage of market participation selected by the user. It makes small and large trades by reacting appropriately to volume jumps.

Iceberg Strategy

The iceberg order strategy records a buy or sell order but does not display the total size of the market orders. Potential buyers see only a small part of the order, and only after that order is executed can they see the next part, and this continues until full execution. The iceberg strategy breaks a large trade into small orders that resemble a real iceberg, with a larger amount of volume hidden underneath.

Trend-following Strategy

The main objectives of the trend-following strategy are: early detection of a trend through various technical analysis indicators, issuing signals for trading in the direction of a trend, and issuing signals to close the trade when signs of a trend reversal appear.

Arbitrage Strategy

In the arbitrage strategy, Forex trading bots, while identifying price divergences in the same or equivalent instruments in different markets, buy cheaply in one market and immediately sells in another, expecting that the prices of the trading instruments will align, closing transactions with a profit. Arbitrage is often considered low-risk, as the trading robot buys assets for a short period, avoiding prolonged exposure to price fluctuations. However, arbitrage profits are typically small, and total earnings depend on transaction frequency.

Scalp Strategy

The scalp strategy is designed for day trading and short-term speculation. High-frequency robots are the most common Forex scalping robots, as they open and close trades in a matter of seconds, even if they make a very small profit of a few pips. Scalping is commonly used in markets with low transaction costs, such as Forex and derivatives.

Pairs Trading Strategy

The goal of the pairs trading strategy, or statistical arbitrage, is to determine the correlation between different market instruments and profit from their imbalances. In small time intervals, one asset can become undervalued or overvalued compared to another. The Forex trading robots analyze deviations from the historical average ratio to identify trading opportunities.

High-frequency trading (HFT)

One subset of algorithmic trading is high-frequency trading (HFT), which is characterized by a very high speed of execution of trade orders. High-frequency trading can bring significant benefits to traders, including the ability to execute trades within milliseconds of small price changes, but it also carries certain risks in a volatile Forex market.

Benefits of Algorithmic Trading in Forex

The benefits of automated trading in Forex include: 

• Save time: Traders don’t need to spend all their time analyzing the market and finding trading opportunities. Algorithms do this automatically and quickly, making smart investments in Forex.
• Control emotions: Many traders make incorrect and irrational decisions due to fear, greed, and high or low confidence. By using algorithmic trading in Forex, this factor is eliminated and all transactions are carried out according to specified rules and instructions.
• Cost reduction: Transaction costs are reduced as algorithms are able to find the best price for buying and selling and divide high-volume orders into small-volume orders. There will also be no need to pay salaries to intermediaries and brokers.
• Implementing complex strategies: Using algorithmic trading, a trader is able to implement complex and multi-faceted strategies. Algorithms can use indicators, frequencies, different timeframes, and off-market data.
• Ability to trade 24/7: Algorithmic trading enables traders to operate in the Forex market around the clock. They can take advantage of opportunities even when they are sleeping. 
• Speed of execution: Algorithms can execute trades within milliseconds, allowing traders to capitalize on incremental price changes quickly and efficiently.

Challenges and Risks of Algorithmic Trading in Forex

Also, there are some disadvantages with algorithmic trading strategies for Forex that every Forex trader should be aware of:

• Errors in programming code: If the algorithm has errors or bugs, it may cause incorrect, illogical, or loss-making trades. To avoid this problem, the algorithm must be well-tested and modified before use.
• Data dependency: Algorithms make decisions only based on available data and cannot take into account other factors such as traders' behavior and emotions, political, social, and economic conditions, and sudden market changes. This may cause algorithms to perform poorly under dynamic and uncertain conditions.
• Competition with other algorithms: Many algorithms compete to quickly find and react to trading opportunities. This may cause prices to change rapidly and put psychological pressure on traders.
• Regulation and Oversight: Many countries have enacted or are in the process of enacting their laws and regulations to oversee algorithmic trading. These laws may limit the performance and profitability of algorithms.
• Algorithm error risk: This risk occurs when the algorithm doesn’t work properly or encounters errors or defects. This may lead to incorrect or uncontrolled execution of trades. To avoid this risk, the algorithm should be thoroughly tested before use.
• Market risk: Sometimes market conditions change and the algorithm is unable to adapt to them. This causes a mismatch between the strategy and the trading results. To avoid this risk, the algorithm should update market data regularly.
• Liquidity risk: This risk occurs when a lack of demand or supply in the Forex market prevents the trader from executing their orders at the desired price. This may result in significant price spreads or order cancellations.

Popular Algorithmic Trading Platforms for Forex

In the following table, we’ve compared the best algo trading platforms for Forex along with the pros and cons:

Steps to Algorithmic Forex Trading

In general, four main steps can be identified in a secure Forex trading process:

1- Defining a trading strategy

The trader must determine forex algorithmic strategies based on their knowledge, experience, and goals. A trading strategy includes the rules and conditions for entering and exiting trading positions, risk and profit management, market and asset selection, market analysis, and trading signals.

2- Algorithm programming

At this stage, the trader must convert their strategy into a programming language suitable for the computer. To do this, the trader must have the necessary technical knowledge and ability or seek help from those who have this expertise. The algorithm must be able to automatically receive, process, and analyze market data, as well as register and execute trading orders and algorithmic trades in Forex.

3- Algorithm testing and optimization

The trader must measure the performance of their algorithm in real or quasi-real market conditions and identify its strengths and weaknesses. For this purpose, the trader can use various methods to test the algorithm.

4- Implementation and monitoring of the algorithm

At this stage, the trader is ready to implement their algorithm in the real market. For this purpose, the trader must activate their account within the framework of the rules and conditions of the Forex market and connect their algorithm to the trading platform. Additionally, the trader must monitor and control the performance of their algorithm and take the necessary measures in case of technical or market problems. 

Conclusion 

You have found that algorithmic trading in Forex is a topic that has attracted a lot of attention from traders today and has a large following. To succeed in this field, you must keep all the points mentioned in mind, as well as follow smart trading in the Forex market in general, and devote sufficient time and effort to it. Perhaps one of the most important benefits of technological development in the world of finance is algorithmic trading.