Forex algorithmic trading and strategies explained

Education / 5 Min Read
Milan Cutkovic / 23 Sep 2021

When you’re new to trading, it’s unlikely that algorithmic trading software is amongst the first things that cross your mind. But algo trading is an important – not to mention very useful – part of trading. 

Forex algorithmic trading, or trading by algorithm, is the process of executing trades using computer programs to analyse data and execute orders in the forex market. Algorithmic traders rely on quantitative methods such as technical analysis for their decision-making.

In this guide we are going to review exactly what forex algorithmic trading is and how it works, the benefits and risks of algo trading, as well as some common forex algorithmic trading strategies used in the market.

What is forex algorithmic trading?

The concept of algorithm trading (sometimes called algo-trading) is reasonably straightforward; it’s really just a more technical way of referring to a form of automated trading. A single algorithm is simply a set of mathematical rules which a computer program follows to solve a specific problem. When applied to forex trading, those problems usually center around a combination of price, timing and volume.

Breaking it down into parts, an algorithm is fundamentally marked by an entry point, an exit point, and in-between those, various sets of rules or actions around determining risk. These can be as simple or complex as the person programming it wants them to be, although, most commonly, they’re complicated.

For example, you might want an algorithm that scans the markets, buying a certain amount of currency at a particular price and selling at another. When writing the set of rules for that algorithm, you could choose to base your criteria only on traditional price movements. But, more likely, you’d want to take into account a much more intricate and interconnected range of factors including profit/loss ratios, historical data, trends and even breaking news.

All these contributing factors are assessed within an environment where the conditions are constantly moving, and often moving very quickly. And therein lies the big advantage algorithms have over human traders: size and speed.

When you sit down in front of your trading terminal and start manually looking for suitable trades to execute, it takes time to filter through the data and determine whether or not a potential trade has the right attributes you’re looking for. And by the time you’ve done your analysis and are ready to hit the button to execute, the market conditions may have changed. Using an algorithm, all the processing effectively gets done instantly. What takes you minutes by hand can be done by an algorithm in the blink of an eye and this can be the difference between a profit or loss, or a big profit/loss compared to a smaller one.

The algorithms don’t just operate one at a time. You can run hundreds of them simultaneously, letting you cover many different positions and follow a broad range of strategies at the same time, even on separate accounts. For someone using algorithms, the possibilities of what they can achieve are seemingly boundless.

MetaTrader 4 algorithmic trading

Source: MetaTrader 4

Can anyone create an algorithm?

Well, yes and no.

Modern trading platforms have made it much easier to create your own very simple algorithms or, at the least, custom indicators. If you’re confident in your own ability, this is something that might be worth pursuing but, by and large, creating complex algorithms is a specialised skill most applicable to those with a background in mathematics, statistics, computer science or similar quantitative background.

Genuinely effective algorithms can take a long time to develop and require extensive and ongoing testing. If you’re not suitably qualified to create your own custom algorithms you can purchase them predesigned, or even work with a programmer to create some targeted specifically for your goals and strategy. Whatever the case, you should always use a demo environment to test comprehensively and make sure your algorithms work as intended. Sign up for a demo trading account to begin testing your algorithms.

You should also keep in mind that an algorithm that worked once, twice or even three times isn’t guaranteed to work the next time. As outlined above, the markets are ever-changing which will affect your rules as time goes on. For example, if your algorithm is based on historical data from the past three years, in another years time the entire data set will likely have changed significantly, requiring adjustments to your algorithm.

It’s easy to see the convenience to be had from automating your trades, but they can also help on a psychological level, removing cognitive bias. When you trade in a more manual fashion, it’s difficult to remove your own predispositions from your decisions –those times where you just have a “good feeling” about a trade.

Algorithms remove emotion from the equation. They don’t work on opinions or feelings, only facts and data. They are, therefore, always objective. However, they’re only as powerful or capable as the rules they’re written in.

As with any form of trading, you need to first determine your objectives and strategy then figure out which tools are the best to help you achieve them. No algorithm is entirely foolproof–not even the most complex ones – but for many traders, their usefulness is well proven.

Forex algorithmic trading strategies

Listed below are some common forex algorithmic trading strategies and some additional ways of using algorithms in your journey to automated trading.

Forex scalping

Forex scalping is a strategy in which traders attempt to profit from small price changes that could occur within a couple of seconds. Algo trading might be particularly suitable for this type of trading as it involves opening a large number of trades per day, and it could significantly improve the execution speed compared to manual trading.

Trend strategy

A trend strategy involves trading in the direction of the trend - i.e. buying when the asset is in an uptrend or selling when the asset is in a downtrend.

Momentum trading 

Momentum trading is another popular short-term trading strategy. While trend traders will generally try to "buy low, sell high", momentum traders are chasing the momentum - i.e. "buy high and sell higher". For example, EUR/USD might be approaching a significant level of resistance at 1.20. If the currency pair manages to breach this level, momentum may start to build as stops get triggered and traders start to buy anticipating that the uptrend will continue.

News trading

If you follow central bank meetings or major news releases, you will have noticed that volatility jumps significantly and price moves abruptly. Very little manual trading occurs during this time, as most institutional traders will have algorithms in place to trade during such events.

Arbitrage trading

Arbitrage trading involves finding price imbalances and profiting from the difference in price. Those price differences can be very small and the opportunities disappear quickly.

Additional algorithm trading strategies:

  • Statistical
  • High-frequency trading
  • Auto-hedging
  • Average price/mean reversion
  • Market sentiment based system
  • Iceberging trading system
  • Price action strategy
  • Combination strategy
  • Algorithmic execution strategies
  • Direct market access

Recommended reading: Ichimoku Cloud trading strategy: Essential guide

What are the benefits of algorithmic trading?

Algorithmic trading has continued to improve over the years and there are some clear benefits that it can help with your trading strategy:

  • Algo trading cuts out the emotions from trading.
  • It can be used as a diversification tool i.e. you may use a second trading account where you trade only manually.
  • It can help you build consistency.
  • Algorithm trading can improve the execution of your trades.
  • With algo trading, it is easy to back test as you can run the algorithm based on past data and evaluate its past performance. This is very difficult with discretionary trading, as there are an endless amount of scenarios.

What are the risks of using algorithmic trading in forex?

While algorithmic trading certainly has its benefits, there are also risks involved. Algos operate at high speed, which means that a bug could lead to notable trading losses within a short time.

Furthermore, you are relying on the algorithm to function efficiently and may find yourself in a situation where you are temporarily out of control.

Algorithms operate based on rules. Removing emotions from trading can be a good thing, but it is a fact that intuition or "gut feeling" does play a role in trading - especially if you spend a significant amount of time monitoring the markets. Algos will not have this advantage.

There are also concerns that algorithms and HFT trading contribute to the rising occurrence of flash crashes. We talk about a flash crash when the price of an asset declines rapidly within a short period of time and quickly recovers. One of the most famous flash crashes happened in 2010 when the Dow Jones index declined more than 1000 points within 10 minutes. The price of many stocks declined rapidly, and the price action alone was sufficient to trigger a large amount of orders which essentially caused an avalanche.

Who uses algorithmic trading?

Algo trading is widely used in financial markets by commercial banks, investment funds, hedge funds, non-bank market makers and retail traders. According to a study by Coalition Greenwich, 40% of institutional FX traders made use of algo trading in 2020 and expect that their usage will increase further in the future.

It is especially important to financial institutions who engage in market making. You may also have heard about high-frequency trading (HFT), which gained significant traction in the past few years. HFT is a type of algo trading that makes use of high-frequency data and electronic trading tools to execute significant volumes at very high speeds.

What is the difference between automated trading and algorithmic trading?

Automated trading is about automating the entire trading process, meaning that the automated trading system takes over the whole process from screening for opportunities in various financial instruments to taking the decision of buying/selling. 

Where as algorithmic trading focuses on the execution process of a trade.

Recommended reading: Forex trading robots: What are expert advisors and how do they work?

 

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The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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