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TRADER'S NOTEBOOK


Automated Trading

02/19/10 02:22:32 PM PST
by John Devcic

Can a self-directed trader use a computer that trades on its own?

Say you’ve had a hard day at work and you need to relax and maybe get some good news. You turn on your computer and find out that you made a nice profit in the market. You were able to do this by just letting the computer make the buying and selling decisions for you. This is not science fiction. Trading firms have been relying on computers to make automated trades for some time now. Is an automated trading computer something you should consider?

In automated trading systems, little or no human intervention is required. They are based on algorithms, which follow step-by-step methods to make your trading decisions. You still have your data, whether it is news or price levels. You still follow a strategy, which you use to make your trading decisions for entering a new trade or terminating an existing one.

CAN A COMPUTER TRADE?
The computer is exceptional at making quick unemotional decisions following an algorithm. The computer is also exceptional when it comes to dealing with numbers. Market data is numbers and market strategy is nothing more than an algorithm. Once the computer receives the numbers or, in this case, the market data as well as the strategy or algorithm, it can be used to initiate or terminate market positions. Institutional traders, mutual funds, and pension funds use these types of trading systems extensively.

Computers can be a great benefit to traders who trade large sums of money because using computers allows them to divide large orders to manage the impact that these orders normally have on the market. They do so by breaking the large orders into smaller ones and entering these smaller orders into the market over a certain time frame. Besides just market data, these computers receive and process market news. These computers get a feed from a news service in a format that can be understood and processed. Like any good trader, the computer will use this news to decide if a market move needs to be made. So you have the integration of news and market data deciphered by an unemotional computer that makes trading decisions based upon a strategy, and a strategy alone.

PROS AND CONS
The biggest positive when it comes to using a computer to make your trades is the removal of emotion from trading. Traders are always trying to avoid making decisions based on emotion. Emotions cloud traders’ minds. Traders, no matter how good they are, can run into a losing or winning streak that clouds their judgments and makes trading much harder. No matter how sound the investment strategy may be, if you use emotions to enter and exit trades, your consistency and profits can and probably will suffer.

Computers can run any kind of trading strategies you require. Computers can be programmed to exit or initiate a trade at preset conditions dictated by your trading strategy. Computers erase errors caused by emotion. They will risk exactly the percentage they have been programmed to risk. Your exits will be met. The other great advantage of a computer is that it will never get tired. It does not need a raise and it does not need a day off. It can analyze markets constantly with no human intervention needed. Computers can handle complex trading strategies or simplistic ones equally.

THE CONS
Constant power is needed in order to run a computer all the time. The big firms will be using not a few computers but a small army of them to do the trading. A dedicated information technology (IT) department is necessary to make sure these computers are up and running. You will also need a constant and up-to-the-second stream of data or a live feed of both market numbers as well as news. Computers do not care about money or profit. Winning and losing trades are handled in exactly the same way without emotion. The strategy will dictate if a computer must change its trading decisions based on winning and or losing streaks. The algorithm it runs needs to be heavily tested before being implemented and used on a daily basis.

The great thing about technology is that self-directed or smaller-scale traders can get the same results for far less money than you would think. On a smaller scale, a trader will have other factors to consider when it comes to using a dedicated computer to make trades. These factors can sometimes be too large a barrier for the trader to overcome.

CAN YOU TRUST A MACHINE?
In the end, the question of trust comes down to two parts. One is the question of trusting the trading strategy. Many traders will spend months testing and backtesting their strategies in order to get it as close as possible to making the most money out of every trade. No matter the amount of the money in the account or the location of the trader or firm, the traders will need to make sure the strategy works before they can use a computer with which to trade. Backtesting is a wonderful tool used to test all trading systems and strategies. The drawback is in trying to make it work perfectly. Be careful not to curb your rules in order to fit the market you are trading in search of better results. What might have worked in the past can prove to be unreliable when tested on the real-time market. Consider software that will allow you to test your system results using live datafeeds but without real money.

The second part of the equation is, of course, trusting something automated. There are many traders who for various reasons do not like or cannot allow a computer to have total control of their money. They would rather make decisions on their own using their own strategy. These traders will make quick decisions and enter and exit a trade before any of the stops are met. These traders are more comfortable relying on themselves. A computer does not care about losing or winning streaks unless your strategy tells it to trade differently based upon a long or short losing or winning streak.

Deciding on the type of trading style you use comes down to testing to make sure you are getting the results you want as well as the level of success you are comfortable with. Many software packages will allow you to backtest a trading system and tell you the number of profitable and unprofitable trades. They will also tell you the difference between them.

For example, let’s say one system you tested had 20 successful trades out of 60. On the face of it, this does not inspire confidence, so you decide to dig a little deeper to find out whether the system is truly successful. You do this by looking at the differences between the winning trades and the losing ones. Say the total loss of the losing trades amounted to $500, while the winning trades amounted to $1,200. Clearly, this system is profitable. The winners gain far more than the unsuccessful trades lose.

LEAVING IT TO THE COMPUTER
Besides just identifying trade entry and exit points, you have to consider how much you are willing to have on the line on each trade. Once you decide your position size, which depends upon your account size, you will have to figure out if you can turn on your machine and walk away. As mentioned earlier, turning over your hard-earned money to a machine that does not care how much money it makes or loses can be daunting for many traders. If you fall into this category, you can try to blend the two.

Obviously, blending automated trading and human interaction will no longer make it purely mechanical. This will also increase the chance of emotion entering the equation. But you can set the software to identify just the entry and exit points but not let it make the trading decisions on its own. You will have to hit the buy or sell button. I know a few traders who have automated trading systems but make the buying and selling decisions on their own based on the trading signals generated by their system. Psychologically, it still lets them feel in control of the trades, even though they are simply doing what the computer would have done anyway.

DATAFEEDS
You will also need to consider the cost of the datafeed you will need to subscribe to. Depending upon the trading strategy you use, you may need to subscribe to real-time market data. You will also need to take into account the brokerage firm you will be making trades through. Some software packages will allow you to make trades directly through a broker. You will also need to look at how many trades you will be making monthly. Brokerage firms charge traders different fees, depending upon the amount of trades they make. Depending upon the size of your operation, you will either be the IT department or need to find someone who can be. While that sounds daunting, it turns out not to be. If your trouble is with the software, then that can be solved by addressing the issue with the company you bought the software from. The problem will be in deciding if you will need a new computer just to run your trading operation.

FINDING THAT BALANCE
Automated trading can be a great benefit for traders, no matter the size of their bank accounts. A sound trading strategy as well as the ability to allow a computer to trade on its own is all you need. Keep in mind that you want to be comfortable with the trading strategy you have the computer employ. Also keep in mind the expenses of having the computer trade unsupervised.

Automated trading may not be for every trader. But if you happen to be the type of trader who likes this idea, you may find the perfect marriage of having your trading strategy employed without worrying about your emotions getting in the way of making money.



John Devcic

John Devcic is a market historian and freelance writer. He may be reached at drmorgus@gmail.com

E-mail address: drmorgus@gmail.com


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