Algorithmic trading isn’t something new on the horizon. In fact, it was introduced in the 1970s. Since technological advancements have various benefits, including fast order executions and low latency, more and more traders are interested in employing algos in their trading principles.
Options traders aren’t an exception in this growing trend. So, today we’ll see some algo strategies for options trading and discuss the pros and cons of using algorithmic trading.
Algorithmic Trading
Is algo trading considered an advanced approach suitable for highly experienced options traders?
If looking for a way to define or categorize algo trading, we can say this is an advanced approach. However, that’s because it costs. Plus, it requires programming knowledge (or hiring a programmer) to set the wanted trading strategy.
For a solo investor, algorithmic trading may be too expensive. You need a huge initial capital for developing and implementing the algo systems. Also, these systems are based on multiple regulatory requirements, and you’ll have to pay fees for software and data feeds.
On the other hand, algorithmic trading is the key to eliminating human error. Regardless of their experience, traders may often make decisions based on emotions and lose money. This is where algo trading is more beneficial than manual trading.
Throughout this article, we’ll discuss the advantages and disadvantages of algo trading. But we aim to introduce you to several algo strategies for trading options.
It’s important to note that these strategies are considered some of the best algorithmic trading methods for various securities.
Algo Strategies for Options Trading
Following trends as a strategy
Following current trends as a strategy is a well-known approach that doesn’t need an introduction.
We may say that monitoring the trend or the movement of the price, and buying and selling accordingly, is the safest trading approach on the market. Of course, this isn’t carved in stone.
When it comes to algo trading, the difference is that the price movement is monitored by a program.
Traders use software to follow the moving averages, channel breakouts, and various technical indicators, such as the Money Flow Index (MFI), moving average convergence divergence (MACD), Relative Strength Index (RSI), Bollinger Bands, etc.
Many traders follow trends because these strategy types are very easy to implement by using algo trading.
Arbitrage
Arbitrage is a strategy used by traders who simultaneously buy and sell the same or similar assets in different markets. The goal is to take advantage of the differences in the asset’s price.
The price differences between markets are very small. They occur as a result of inefficiencies in the market. So, arbitrage uses these inefficiencies for profit. Also, this strategy helps in resolving those differences.
Therefore, how is algo trading suitable for arbitrage? With technological advancements, there are fewer price differences between markets. Even when they occur, they’re resolved quickly.
Implementing arbitrage through algo-trading programs is much easier than using the strategy for manual trading. That’s because an algorithm will spot price differences much quicker and easier than you can, so traders can act faster.
Mean reversion
It’s important to note that mean reversion is a theory. It’s not a term that refers to a set of trading techniques. Why is it on this list? Based on mean reversion, you can build a trading strategy.
This theory says that one asset’s price will ultimately return to its average level after a period of up-and-down movements.
So, traders monitor these movements and try to profit from price changes. They believe that the timeframe through which they act it’s crucial, as, according to the theory, the asset will revert to its average.
Regarding options, the mean reversion theory is used for observing an asset’s volatility compared to its long-term average.
Now, traders who want to build a trading strategy based on mean reversion track the asset for extreme changes and open positions accordingly. Using an algorithm for mean reversion is more practical than monitoring the events manually.
The system will enable you to place trades when the price of the underlying breaks out or enters its average range. In fact, with algo trading, those traces are placed automatically.
Volume
Volume in the stock market shows how often stocks are traded. For options (and futures), the volume will represent the number of traded options contracts during the trading day.
To put it simply - higher volume means greater liquidity. It means that there are investors interested in the market, so it's easier to trade.
Now, it’s important to note that monitoring the volume of options contracts it’s not enough to build a strategy. However, this is a vital parameter for establishing a trading technique.
With algo trading, you won’t have to pay so much attention to these percentages. The program you use will measure and track options volume. If you want to trade based on liquidity, the program will place trade automatically when a certain volume percentage is reached.
Time-weighted average price
Time-weighted average price, or TWAP, is the average price of an asset measured over a specified time. The use of the TWAP strategy is common among high-volume traders. That’s because making a large order will impact the market and probably result in significant price movements.
Simply put, traders use TWAP to divide one large order into several smaller traders over a pre-specified period.
Options straddle
Options traders frequently use straddles as a part of their strategies. To have a straddle, you have to hold two positions (a call and a put) on the same underlying asset. The call and the put must have the same expiry and strike price.
Now, you have two ways to profit from straddles. You can implement directional play. In this case, the asset may go high or low, meaning its direction it’s unknown. This is known as implied volatility, and if you use it as an algo strategy, you have to write the wanted instructions in the program.
The other way is by implementing the volatility play. In this case, traders speculate that the asset’s volatility will increase because of an upcoming event. Usually, many traders buy the asset. Logically, many options traders set up a straddle.
Regardless of the scenario or the play type you choose, you can give the right instructions to the program and let it make the trade for you.
Mathematical model
Another easy-to-do strategy, if you’re interested in algo trading, is the mathematical model-based method. Basically, various mathematical models are created to track and study price trends. Studying the price trends results in a model that includes patterns.
Traders use these models as trading strategies because they believe the asset’s price will move according to the already-known pattern.
Logically, algorithms are suitable for model-based strategies because they can monitor and analyze multiple markets, collect historical data, and make patterns based on that analysis.
Requirements for Algo Trading
When we say requirements for algo trading, we’re talking about the technical conditions that you have to meet to benefit from this trading style.
It goes without saying that the most important thing that’s required is trading knowledge and a deep understanding of the market. This way, you’ll be able to give the right instructions to the algorithm.
So, the technical requirements start with you giving the instructions to a developed computer program that will trade instead of you. Simply put, you can implement whichever strategy you like if you give the right instructions.
Technically, the list of algo strategies for options trading is as long as the list of possible options strategies. Practically, it’s not the same. That’s because options trading includes too many complex parameters that have to be monitored, and not all of them are coded into algorithms.
List of technical requirements
- Software for implementing the wanted trading strategy
- Excellent network connectivity
- Access to trading platforms
- Access to market data feeds
- Backtesting the program
- Access to historical data for backtesting
Programming or choosing software
This is the most important requirement, as it’s the base of algo trading. You have three options when it comes to the piece of software you’ll need - you can program it yourself, hire a programmer, or find a pre-made algo trade.
Now, developing a program requires advanced programming knowledge and skills. You’ll also need knowledge of at least one computer language, such as Java, Python, C++, etc.
Even though it’s more challenging, building the software yourself has a huge advantage - you can customize it to match your needs or specific trading style.
If you don’t know how to develop trading software, you can purchase a pre-made one. Be aware that choosing this option will limit your trading flexibility because pre-made programs are designed generally and not to match a specific trading style.
Benefits of Algo Trading
Algo trading comes with multiple benefits. Of course, the most important benefit is that the algorithm will open and close positions way faster than you. This saves time because the computer executes the orders at optimal conditions.
A crucial advantage of using algorithms for trading is that the computer eliminates the risk of human error in terms of emotions. The computer will not open or close trading positions based on its feelings, as you will probably do.
Further, with algo trading, you’ll get instant order placement. Besides executing orders at the optimal conditions (the conditions you have to set by giving instructions to the algorithm), the orders are placed instantly after those conditions are met.
In simple words, with algo trading, you’ll enjoy the benefit of low latency. The level of latency you’ll get by using algo strategies for options trading is practically impossible if you manually place orders.
Last but not least, algorithms can automatically check multiple market conditions. Again, this isn’t possible if you trade manually.
Disadvantages of Algo Trading
While algo trading looks like a fairytale in which you get rich with a few simple clicks, it also comes with various drawbacks.
First on the list is the inability to deal with the black swan events. Black swan events are unpredicted disruptions in the market. Algorithms can’t deal with these disruptions because they use mathematical models and historical data to predict future movements.
Another disadvantage is something we already mentioned earlier in this article. To use algos as you want, you have to develop them yourself. Otherwise, pre-made programs are limited and may not match your preferences.
Further, algo trading requires large capital. Since not every trader can afford it, algo traders may significantly impact the prices, resulting in losses for those who don’t act fast enough and change their orders.
The most significant drawback of algo trading is that it’s subject to various regulations. The trader has to comply with all requirements, which is costly and time-consuming.
High-Frequency Trading
You should know that high-frequency trading, as a method, takes a larger percentage of algo trading these days. In fact, when someone says algo trading, they mean high-frequency trading in 99% of the cases. Therefore, it’s important to understand the HFT concept if you want to implement algo strategies for options trading.
High-frequency trading includes a large number of orders that are executed within seconds across multiple markets and based on multiple decision parameters. Of course, to capture the optimal conditions and execute those orders, the trader relies on preprogrammed instructions.
So, we can say that HFT is a form or type of algo trading. We’ll see who uses algo trading in the following section.
Who Uses Algo Trading?
Long-term investors use algos when they want to purchase assets in large quantities. They use algos because buying large quantities at once will most likely influence the assets’ price. So, they place numerous orders that are executed within a few seconds or during a more extended period.
Algo trading is also used by market makers, speculators, short-term traders, and arbitrageurs. They use algos because they can benefit from automated execution. Plus, trading at a fast pace creates liquidity in the market, which is another benefit for the sellers.
Algos are also used by trend followers, pairs traders, and hedge funds. They use algorithmic trading because of the convenience it provides. They give instructions based on their trading styles and let the algo trade for them.
Conclusion
To conclude, algorithmic trading is superior to trading manually in terms of speed and latency and eliminating the risk of human error. However, there are as many disadvantages as there are benefits.
So, we advise you to consider all factors carefully before investing your money in a trading program.
Suppose you want to take advantage of technology and reduce the amount of time you spend to find suitable options manually. In that case, you can try a less invasive and way more cost-effective technology like an options-alert platform.
Foolproof Options is the best choice you can make because you’ll get at least three options alerts per week for $97 per month. Plus, if you don’t make any profits from using the platform’s plan, you’ll be eligible for a 200% refund on your membership.