The rage of Algorithmic Trading or Algo Trading as we better know it, has been thriving with no end since its introduction in India in 2008. The orthodox houses of wealth who frankly cared so little about terms like sophistication & strategies suddenly felt intimidated by geeks of the tech world. The equity markets have undergone a radical overhaul since then.
Before delving into our lesson, let us get a clear framework to operate & understand a few nuances.
Informally speaking, traders fit into either of the two ranks:
1) Discretionary Traders
They call the shots in terms of when to enter or exit the trade, how to manage the position, fix an appropriate stop loss, and others. Human judgement and emotions play a significant role as trades punched their trades solely based on gut feel. The biggest advantage herein is the flexibility to adapt beyond the imaginable.
2) Systematic Traders
These traders rely on computer systems and software to automatically punch their trades. An algorithmic trading program is also backed by technical analysis, and the degree of human intervention is abysmally low. High-Frequency Trading (HFT), Algorithmic Trading, Pair Trading, Momentum trading, and Passive Index Tracking are all subsets of Systematic trading. Although systematic trading is prominently a foothold of Investment Banks and Hedge Funds, retail participation in this segment is steadily on the rise.
Some differences between Discretionary trading & Systematic trading:
- In discretionary trading, human judgment & emotions play an important role, whereas systematic trading is fully automated, with no manual intervention.
- Discretionary trading has no defined rules, but systematic trading relies on pre-defined rules that are encoded in trading software.
- In discretionary trading, risk management is crucial to avoid huge losses, but risk management is incorporated into algorithms for systematic trading.
- Discretionary trading requires constant monitoring of the markets, but systematic trading does not require tracking as software is already monitoring the markets.
- In discretionary trading, the markets must be monitored continuously, but in systematic trading, the markets are monitored by software.
- Since discretionary trading rules vary in how the trade is executed, there is no valid assessment of success; however, for systematic trading, strategies are backtested against historical data & then implemented.
- Discretionary trading may result in heavy losses if there is any slippage, but systematic trading has low slippage as stop losses are predetermined.
- Discretionary trading is preferred by retail punters. Imagine these traders as a small-cap stock with the potential to give a multibagger return. Institutional players like investment banks, hedge funds, etc., prefer systematic trading. Imagine them like large-cap stocks with good compound growth.
Elaborating a little further on the slippages part, Consider a Discretionary Trader who implements a Long Call Butterfly strategy on the Nifty 50 Index. The trader observes that the index is moving against his position & decides to exit with a small profit. By the time he squares off the ITM call options, the OTM call options may significantly appreciate. This minuscule time lag has the potential to wipe off the entire profits generated by theta decay over multiple trading sessions.
On the other hand, a Systematic Trader would have made use of pre-determined price targets & stop-losses in the course of routine trading. Automated trading softwares would exit all four legs of the strategy at one go.
(Refer to this module for a better understanding of The Butterfly strategy)
This differentiation is not to say that one is better than the other or so but to draw clear lines between the two. In fact, a superior trading system would be one that combines the best of both worlds & makes it work to their advantage.