Let a computer make up your mind about when it's best to buy and sell
Call and put
Some traders, for instance, sell “call” and “put” options on shares which compel them to sell when the share price rises and buy when the share price falls.
Call and put options are similar to insurance contracts. The seller receives a premium but guarantees that he will buy the share if it falls below a certain price (put option) or sell the share if it goes above a certain price (call option).
The benefit for the trader selling the options is that he receives the premium from selling calls and puts. More importantly, it forces him to buy when the share price falls and sell when the share price rises.
Irish stockbroker Goodbody offers a limited range of derivatives to its wealthier clients but only after a vigorous vetting procedure to make sure that investors understand the risks.
Spotting anomalies is a more sophisticated form of algorithm trading. It works best when carried out across different asset classes.
For instance, in 2007, some investors noted that bank share prices were rising at a time when credit traders were charging a much higher premium to insure the same banks against default. Algorithms saw this anomaly and profited from it. Traders (or more precisely computers) sold bank shares and repurchased them at much lower prices. Even traders who knew nothing at all about the looming banking crisis benefited.
Simple algorithm trades won’t make you millions but they are worth understanding. Algorithm trading over different asset classes is more for the dedicated investor and may involve investing in trader screens to get data on shares, currencies, commodities and interest rate volatility.
Many traders make the mistake of mixing leverage with algorithm trading. In essence, leverage is where you borrow money to buy shares. If you own shares on borrowed money, you are forced to sell when the share price falls and therefore you do the opposite of what Buffett suggests.
Derivatives can make you rich but, as Seán Quinn discovered, they’re risky and can change your life very quickly. As financial derivatives business IG Index enters the Irish market, the best advice is to start off with small amounts and set strict loss limits. Otherwise emotions are bound to overrule any algorithm you create.
Cormac Butler is the author of Accounting for Financial Instruments and has led training seminars for bank regulators and investors on financial risk. He has traded equities and options