Stock Trading 101: How Does a Trading Algorithm Work?

Did you know that 56% of Americans say they invest in stocks? Whether you’re new to stocks, or an experienced trader, you’ve likely heard of algorithmic trading.

Unfortunately, there’s a big difference between knowing about a trading algorithm and understanding it. That’s why we made this guide. In it, we’ll go over how these types of algorithms work.

We’ll also discuss the pros and cons, strategies, and technical requirements. That way, you can decide for yourself whether or not they’re right for you.

What Is an Automated Trading System?

An automated trading system is a computer system that utilizes a trading algorithm. Essentially, you’re programming this computer to buy and sell stocks on certain exchanges.

How do the computers know when to buy? Because of predetermined guidelines that you’ve given them. There are a variety of algorithmic trading strategies out there.

That means you can customize them to your specific trading preferences. In some cases, automated trading systems use a simple technical analysis to provide a hands-off approach to inventors.

However, more advanced systems can use advanced mathematics and statistics to reach their decisions. So, you can make it as straightforward or detailed as you want it.

There are a variety of types of trading systems. Some are run entirely by algorithms. Other ones use rules, but a human can override them at any time. Discretionary trading, often used by day traders, uses no algorithms at all.

How Does Algorithmic Trading Work?

Here’s a basic example of how algorithmic trading works. Let’s say a trader wants to buy one hundred shares of a stock when its moving average goes from 100-days to 200-days.

In addition to this, he also wants to sell the stocks if they fall below a 200-day moving average. The trader can easily plug these two instructions into a computer program.

From there, the computer will automatically monitor both the stock price and any moving average indicators. If it sees the conditions that the trader set it will automatically buy or sell them.

This is a big deal because it means the trader no longer needs to obsessively monitor live stock prices and graphs. However, sometimes automated trading systems require a more complex strategy.

For these types of situations, the trader will need to work closely with a computer programmer.

Together they can create a system that’s more attuned to the trader’s specific strategy. It was more expensive. But, if it’s successful then it also means higher returns.

Benefits of a Trading Algorithm

There are a lot of benefits that come with trading algorithms. First, it ensures that trades are made at the best possible prices available to you. What’s more, the trade order is done as instantly and accurately as possible.

There’s no room for human error unless it’s in the programming. This instantaneous nature also means that you’re able to avoid any potentially significant price changes.

When you algo-trade you get reduced transaction costs. An automated trading system can check on multiple market conditions at the same time. Unless you have a team of people this would be impossible to do by yourself.

In many cases, you can backtest a trading algorithm strategy against past historical data to see if it’s successful. That way, you can gain confidence in your strategy.

Finally, it helps root out common mistakes made by traders. If you’ve ever traded before you know that emotional or psychological factors can get in the way of what would have been a successful trade.

An algorithm eliminates these factors in stock trading.

Drawbacks of a Trading Algorithm

Sadly, trading algorithms aren’t perfect. Many people think that trading algorithms are completely hands-off systems. But oversight is still required to make sure that everything is running according to plan.

Next, past performances aren’t always an indicator of future success. While these simulations can be valuable, market conditions are volatile enough to throw curveballs now and then.

Finally, there is the potential for either mechanical failures or disruptions in the connectivity.

What Are the Different Types of Strategies?

There are a variety of trading algorithm strategies out there. The most popular ones tend to be trend-following strategies. These strategies usually follow specific trends, like moving averages, price level movements, and channel breakouts.

If you want the easiest possible strategy, these are your best option. Instead of relying on complex predictive analysis, these algorithms just look for desirable trades.

However, it’s far from the only strategy. Here are some of the other common ones you can find:

  • Arbitrage opportunities
  • Mathematical model strategy
  • Trading range or mean reversion
  • Volume-weighted average price (also known as VWAP)
  • Time-weighted average price (also known as TWAP
  • Percentage of volume (or POV)
  • Implementation shortfall
  • Index fund rebalancing

Still not sure what strategy to pick? Consider this award-winning strategy system offered by It will walk you through a step-by-step strategy to get your algo trading off the ground.

Technical Requirements Needed for a Trading Algorithm

To implement a trading algorithm, you will need some knowledge of computer programming. Alternatively, you can hire programmers or purchase pre-made trading software that uses algorithms.

To place an order, you will also need constant access to uninterrupted network connectivity. If you’re making your algorithm you will need an infrastructure to properly test it before sending it into real markets.

Enjoy Learning About Trading Algorithms? Keep Reading

We hope this article helped you answer the question, how does a trading algorithm work? As you can see, this is a great way to automate your stock trading.

But you need to have a dependable strategy before you proceed. Otherwise, it’s easy to do more harm than good.

Did you learn something from this article? If the answer is yes, keep reading to find more similar educational subjects.