What is rule based trading?

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Welcome to another module of Smart Money. Up until now, we’ve seen topics ranging from the evolution of investing options to tax laws for NRIs. In this one, we’re going to look at something completely different yet relevant. And that is rule based trading.

You may have probably heard about this before, but if you haven’t, we’ll help you understand rule based trading. It is a unique trading mechanism that has been traditionally used by stock brokers, fund houses, and investment banks. Of late, rule based trading has found a lot of takers from the retail segment, with an increasing number of individuals showing interest in learning about this kind of trading. With this, let’s get right into the topic.

What is rule based trading?

When you actually trade in the stock market, everything from the decision to buy or sell an asset, placing an order, squaring off your positions, and liquidating your holdings are all dictated by you. All of the trading decisions are made by you based on the information available to you and your own judgement, right?

Here’s where there’s a slight problem. Human beings tend to be emotional, with many conscious and subconscious biases. We’ve covered them quite extensively in the previous modules of Smart Money. And with so many biases and emotions holding us back, it is extremely hard to truly take unbiased and accurate judgments and trading decisions.

That said, fortunately, there’s a way to circumvent this issue and put yourself in a position where your trading decisions are not influenced by emotions or human biases. This is where rule based trading comes into the picture.

Rule based trading is a mechanism that involves automating the entire trading process. Right from the trading decision to order placement and position exit, all of the trading activities are automated and carried out without any user intervention. All that you’re required to do is define the trading set-up using rules and sit back and relax. The rule based trading system will execute the trade along the lines of the rules and conditions set by you.

One of the primary advantages of rule based trading systems is that you don’t have to do anything once you’ve set the system in motion. Since your trade is defined by a certain set of rules, it will get executed only if the conditions and rules are met. This ensures that your trade is objective and free from biases and emotions.

 

Rule based trading: An example

Now that you’ve gotten a fair idea of what rule based trading is, let’s take a look at an example.

Say you’re interested in the stock of Infosys Limited. However, the stock is currently overvalued. Also, you see that it is nearing its immediate resistance level. Now, if you were to trade normally, you would have to constantly monitor the stock till it reaches the price level that you’re comfortable with. And since you’re really interested in the stock, your emotions may take over and you may place a buy order much earlier than you would have otherwise done, which could lead to losses.

Here’s where a rule based trading system can help you overcome your biases, and the need to manually monitor the situation. With rule based trading, you could train the system to recognize the resistance levels and support levels of a stock and place orders accordingly.

Therefore, if you were to employ a rule based trading system here, it would automatically monitor the stock’s price movements constantly, recognize that the stock has hit a resistance level and is going down, and place an appropriate buy order near the stock’s support level. Your part would only be limited to defining the rules and conditions for the trade. Everything else from monitoring the stock to executing the trade would be taken care of by the rule based trading system.

Wrapping up

This should help you understand what rule based trading is and how it can effectively transform the way you trade. In the next chapter, we’ll take a look at the benefits of rule based trading.

A quick recap

  • Rule based trading is a mechanism that involves automating the entire trading process. 
  • Right from the trading decision to order placement and position exit, all of the trading activities are automated and carried out without any user intervention. 
  • All that you’re required to do is define the trading set-up using rules and sit back and relax. 
  • The rule based trading system will execute the trade along the lines of the rules and conditions set by you.

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FAQ'S

Yes, definitely. With the right resources and the adequate knowledge about how to set up a rule based trading system, anybody can practice this strategy. Today, there are many stock broking houses that offer user-friendly APIs to make rule based trading more accessible for everybody.
Rule based trading eliminates human bias and can be particularly useful in a volatile market. So, while it does improve the chances of earning better returns, there is no way to guarantee a profit in trading - with or without rule based trading.
You can adopt rule based trading strategies in any kind of market - be it bullish, bearish or sideways. Rule based trading can also be very useful when the market is volatile, since it can help you execute trades quickly.
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