Exploring Automated Trading Systems: Benefits and Drawbacks

Automated trading systems allow traders to execute predefined rules, enhancing efficiency and reducing emotional bias. While they account for 70-80% of U.S. stock trades, challenges like reliability and overfitting must be managed for effective use.

TL;DR Automated trading systems use algorithms to execute trades based on predefined rules, handling 70-80% of U.S. stock trades in 2024. They provide benefits like emotion-free trading, precise backtesting, and fast order execution, while also posing challenges such as system reliability, the need for constant supervision, risks of overfitting strategies, and potential fraud. Successfully using these systems requires balancing their advantages with their inherent drawbacks.

Defining Automated Trading Systems

Automated trading systems—also known as mechanical trading systems, algorithmic trading, or system trading—enable you to set precise rules for entering and exiting trades. Once you’ve programmed these rules, a computer can execute them automatically.

As of 2024, automatic trading systems account for 70% to 80% of shares traded on U.S. stock exchanges.

By transforming your specific entry, exit, and money management strategies into automated systems, you allow computers to handle the execution and monitoring of your trades. One of the key advantages of automating your strategy is the reduction of emotional decision-making, as trades are executed automatically once predefined criteria are satisfied.

Your trade entry and exit rules can range from simple conditions, like a moving average crossover, to more complex strategies that require a deep understanding of the programming language used by your trading platform. Alternatively, you might rely on the expertise of a skilled programmer to develop these systems for you.

To implement an automated trading system, you'll typically need software connected to a direct access broker. Each platform has its own proprietary language for defining specific rules.

For instance, the TradeStation platform utilizes the EasyLanguage programming language, while NinjaTrader employs NinjaScript. In addition to these, Cryptohopper offers a more accessible option for crypto traders.

On Cryptohopper, you have a user-friendly interface that allows you to connect and create an automated trading system on a crypto exchange without needing any coding knowledge.

Crafting Your Trading Rules

Leveraging Strategy Wizards

Many trading platforms feature strategy-building "wizards" that allow you to select from a variety of common technical indicators. These tools help you create a set of rules that your system can execute automatically.

For instance, you might set a rule to enter a long position when the 50-day moving average crosses above the 200-day moving average on a five-minute chart for a specific trading instrument.

Additionally, you can specify the type of order—such as market or limit—and decide when the trade should be triggered, whether at the close of a bar or the open of the next one, or simply use the platform’s default settings.

Developing Custom Indicators and Strategies

If you seek more flexibility, programming your own custom indicators and strategies might be the way to go. This often involves collaborating closely with a skilled programmer to develop a system tailored to your specific needs.

While this approach requires more effort compared to using a platform’s wizard, it allows for a higher degree of customization and can lead to more effective trading strategies. Keep in mind, however, that no investment strategy can guarantee success.

Once your rules are in place, your computer will continuously monitor the markets for buy or sell opportunities that match your strategy’s criteria. Depending on the rules you've set, the system will automatically generate orders for protective stop losses, trailing stops, and profit targets as soon as a trade is entered.

In fast-moving markets, this ability to instantly execute orders can be critical, potentially turning a small loss into a manageable one if the trade moves against you.

The Benefits of Automated Trading Systems

Emotion-Free Trading

With an automated trading system, you eliminate the emotional aspects of trading. This helps you stick to your plan more consistently. Since your trades are executed automatically once your criteria are met, there's no room for hesitation or second-guessing.

Whether you tend to hesitate to enter a trade or have a habit of overtrading, automation keeps your actions aligned with your strategy.

Backtesting Your Strategy

Automated systems allow you to apply your trading rules to historical market data, testing the viability of your ideas without any ambiguity. Every rule you set must be precise, leaving no room for interpretation.

This precision lets you evaluate and refine your strategy thoroughly before risking real money. By backtesting, you can understand your system's potential performance and calculate the expected returns based on your risk parameters.

Maintaining Discipline

When your trading rules are predefined and executed automatically, maintaining discipline becomes much easier, even in volatile markets. Emotional factors like fear or greed often lead to deviations from your plan, but automation ensures that your strategy is followed exactly as designed.

Additionally, automated systems reduce the likelihood of "pilot error," such as incorrectly entering the size of an order, ensuring that your trades are executed correctly every time.

Speedy Order Execution

Automated trading systems respond to market changes instantly, generating orders as soon as your trade criteria are met. This rapid response can significantly impact the outcome of a trade, as entering or exiting a position just seconds earlier can make the difference between a profit and a loss.

Once a position is initiated, the system automatically places all related orders, including stop losses and profit targets, preventing delays that could lead to unfavorable trade outcomes.

Expanding Your Trading Opportunities

Automation allows you to manage multiple accounts or strategies simultaneously, effectively diversifying your trading activities. This capability spreads your risk across various instruments and creates a hedge against losing positions.

What would be incredibly time-consuming and challenging to achieve manually is efficiently handled by a computer in milliseconds. Your system can scan multiple markets for opportunities, generate orders, and monitor trades all at once, maximizing your trading potential.

Potential Challenges with Automated Trading Systems

System Reliability Issues

Automated trading might seem straightforward: configure the software, set your trading rules, and let it operate. However, the reality is more complex. Automated systems rely on continuous connectivity and robust infrastructure. If your internet connection drops, an order might fail to reach the market.

Additionally, discrepancies can arise between the trades your strategy theoretically generates and what the trading platform actually executes. Expect a learning curve when implementing automated systems and consider starting with smaller trade sizes to fine-tune your setup.

Necessity of Ongoing Supervision

While the idea of setting up your system and stepping away is appealing, automated trading requires regular monitoring. Technical issues like connectivity interruptions, power outages, or unexpected computer crashes can disrupt your trading activities.

Without supervision, anomalies such as incorrect orders, missed trades, or duplicate entries might go unnoticed. Keeping an eye on your system allows you to quickly identify and address these issues, ensuring your trading remains on track.

Risks of Overfitting Your Strategy

Backtesting can give your trading strategy a solid foundation, but over-optimization poses significant risks. Overfitting happens when a strategy is too closely tailored to historical data, making it perform well in simulations but poorly in live markets.

Adjusting your parameters to achieve near-perfect results during backtesting can lead to a strategy that fails when applied in real-time trading. It's crucial to avoid the temptation of creating a "perfect" plan and instead focus on developing a robust strategy that can adapt to live market conditions.

Protect Yourself from Fraudulent Trading Systems

Be Wary of Unrealistic Promises: As you explore different trading systems, keep in mind that if something sounds too good to be true, it likely is. The market is rife with scams that promise high returns at minimal costs. To safeguard your investments, approach such claims with skepticism and diligence.

Carefully Evaluate Costs and Ask Questions: Before committing any funds or opening a trading account, scrutinize all associated costs. Ensure you understand what you're paying for and don't hesitate to ask questions. Transparent systems will provide clear explanations, helping you avoid unexpected losses down the line.

Conduct Thorough Research: Invest time in researching the trading system you're considering. Familiarize yourself with its features, performance history, and the credibility of its creators. Reading the terms and conditions is crucial to understanding what you're agreeing to and to avoid any hidden pitfalls.

Verify Testimonials and Reviews: Look for genuine testimonials and reviews from reliable sources. Third-party websites and financial regulatory platforms can offer unbiased insights into the system's legitimacy. Authentic feedback from other users can help you gauge the system's effectiveness and trustworthiness.

Look for a Trial Period: A legitimate trading system often provides a trial period, allowing you to test its functionality without a long-term commitment. Be cautious of systems that do not offer this option, as it may indicate a lack of confidence in their own product or an attempt to conceal fraudulent practices.

Utilizing Server-Based Automation

You have the option to operate your automated trading systems through a server-based trading platform. These platforms often provide a range of commercial strategies for purchase, allowing you to either develop your own systems or host existing ones on the server.

By subscribing to such services, your automated trading system can continuously scan for opportunities, execute trades, and monitor market conditions, with all orders managed directly on the server. This setup typically ensures faster and more reliable order executions, enhancing the overall efficiency of your trading operations.

Bottom Line

Automated trading systems represent a powerful evolution in the world of investing, offering traders unparalleled speed, precision, and the ability to execute complex strategies without the influence of human emotions.

By leveraging technology to enforce discipline, conduct thorough backtesting, and manage multiple trading opportunities simultaneously, these systems can significantly enhance trading efficiency and potential profitability.

However, the benefits come with their own set of challenges. Ensuring system reliability, maintaining ongoing supervision, avoiding overfitting, and safeguarding against fraudulent schemes are critical considerations that traders must address to harness the full potential of automated trading.

Ultimately, the decision to implement an automated trading system should be based on a careful evaluation of one’s trading goals, technical expertise, and risk tolerance. For those willing to invest the necessary time and resources into developing and monitoring their systems, automation can provide a competitive edge in the fast-paced financial markets.

As technology continues to advance, automated trading systems will likely become even more integral to successful trading strategies. By balancing the advantages with a mindful approach to the inherent risks, traders can effectively utilize automated systems to achieve their financial objectives.