What is autotrading, and how does it work?
Simply put, autotrading is allowing a trading system to automatically place trades on your behalf in a brokerage account. Previously, the choices available to retail traders, in order of sophistication, were:
1) Pick and choose stocks on their own
2) Follow gurus like Jim Cramer of Mad Money fame, or follow a newsletter
3) Invest in a mutual fund and have a professional manager pick stocks for a general pool of investors
4) Set up a separately managed account, overseen by a professional manager and partially tailored to the needs of the individual client (such as implementing tax harvesting strategies, or excluding certain stocks from consideration)
5) Invest in a hedge fund
Using trading systems, the strategies in any or all of these choices are made available to retail traders.
Trading system: a trading system, at its most basic level, is a set of rules by which trades are made. For example, buy when a stock is above its 20 day moving average, and sell the stock when it falls below its 20 day moving average. Either a person can manually follow these rules, or a computer can be programmed to automatically monitor the market and execute when these criteria are fulfilled. Trading strictly based on rules or algorithms is also called systematic trading. Trading by something other than what rules dictate (e.g. on a psychological basis, on a feeling, on information not taken into account by the rules) is calleddiscretionary trading. For purposes of our discussion today, we will focus on systematic trading.
Systems can use a variety of rules to determine when to make a trade. In the example above, technical analysis is the primary driver of the trading system, but fundamental analysis is also a popular method of trading.
Technical analysis: This is analysis of historical data related to the instrument in question (e.g. a stock, foreign exchange pair, index, etc.) to try and discern clues as to how the instrument will behave in the future. This can involve looking at statistical measures, how volume has changed, or even if the chart resembles certain repeating price patterns. Generally speaking, technical analysis doesn’t put value on fundamental data–or to put it more precisely, does not directly value that data. Technical analysis assumes that fundamental data is already reflected in the chart.
Fundamental analysis: This is the traditional way of deciding if a stock is cheap, and should be bought, or expensive, and should be sold. Examples include studying a company’s earning growth, price to earnings ratio, or dividend policy. Fundamental analysis helps determine the characteristics of the instrument on an economic basis (does this forex pair correctly discount likely interest rate changes? is the stock trading at a discount to its peers?)
Recently, as processing power has increased and internet bandwidth become cheaper and more abundant, some of the most sophisticated trading systems place a trade as soon as a piece of news is reported (e.g. a company’s earnings report or on a more macroeconomic level, jobless claims), or even based on the way people are tweeting about a company on Twitter.
Given the speed at which the markets move today, and the interconnectedness of the global economy, most trading systems today are automated.
Next time, we will explore an overview of the options available today for retail traders to participate in trading systems.