Introduction to rule-based trading



In the previous chapter, we saw a broad overview of how investments and finance can benefit from technology. In this one, we’re going to be taking up one specific area - trading - and see how technology has transformed this practice. You may have read about the rising popularity of rule based trading in recent years.

But first, let’s back up a bit. What is rule based trading anyway?

Rule based trading: An overview

When you think of trading on the stock markets, what is it that comes to mind first? A ‘buy’ order followed by a ‘sell’ order, right? And some profit from those transactions. Now, placing one set of orders may be easy for an individual. But as you’re no doubt aware, it takes a lot more than that to generate consistent and reliable returns. Hundreds or thousands of transactions, in fact. At extremely high speeds. Clearly, that’s a superhuman task - one that an ordinary trader cannot accomplish. But rule-based trading can help here.

What is rule based trading?

Rule based trading is a kind of trading practice that involves the use of a preprogrammed set of instructions or rules. A rules based trading system makes use of computers that are programmed to follow the set of clearly defined instructions. These instructions help the machine place multiple trade orders at extremely high speeds, so the trader can ultimately gain from the net results of those orders or transactions.

Common rule based trading strategies

A rules based trading system can help a regular trader like you take advantage of opportunities that are otherwise considered beyond the reach of the average individual. With the power of tech-driven rule based trading, there are many trading strategies that you can employ. Here’s a closer look at the most common strategies.

  • Arbitrage strategies

Many stocks are listed on both the NSE and the BSE. And there’s generally a price difference between these two marketplaces - for the same stock. Arbitrage strategies help you take advantage of these differences. With the right rule based trading strategies in place, you can buy assets at lower prices from one marketplace and sell them at higher prices on another marketplace.

  • Trend-following strategies

There are many technical indicators that can help traders make the most of prevailing market trends. Metrics like moving averages, price level movements and channel breakouts, among others. A rules based trading system can help you implement orders that are in alignment with any desirable trends prevailing in the market. This takes the guesswork out of the equation, and you need not spend valuable resources on complex predictive analysis.

  • Rebalancing strategies

Index funds in the market are benchmarked to specific market indices. And periodically, these funds are rebalanced in order to keep them on par with the indices they reflect. Traders can make use of rule based trading to benefit from these rebalancing exercises. Without the backing of a rule based system, it is next to impossible to take advantage of the price movements associated with rebalancing.

  • Mean reversion

One of the many theories that run in the market is that despite the highs and lows in the price of an asset, it will eventually revert to the mean value. Rule based trading strategies can help traders make the most of these mean reversion opportunities, because whenever the price of an asset goes to either extreme end, it is expected to move in the other direction sooner than later.

What are the benefits of rule based trading strategies?

A rules based trading system can help traders in many ways. Here’s a preview of the many advantages you get to experience by adopting rule based trading.

  • Instant and accurate order placement
  • Order execution at best possible prices
  • Precisely timed traders 
  • Lower transaction costs
  • Reduced risk of manual errors
  • Bias-free and unemotional trading

Wrapping up

Rules based trading systems can assist short-term traders, long-term investors and systematic traders. No matter which category you belong to, you only need to find the right set of rule based trading strategies to help you achieve your goals.

And as you’ve seen above, rule based trading has so many advantages. Today, it’s more accessible than ever to the average trader. Many stockbroking houses have come up with their own versions of trading APIs to help interested traders upgrade how they buy and sell on the stock market. Like Angel Broking’s very own SmartAPI, which helps traders build their own rule based trading strategies.

A quick recap

  • Rule based trading is a kind of trading practice that involves the use of a preprogrammed set of instructions or rules. 
  • These rules are executed by a computing system to place orders and carry out the trades as specified in the preprogrammed set of instructions. 
  • Rule based trading strategies include arbitrate trading, trend-following strategies, mean reversion and rebalancing strategies.

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Generally, anybody with a few basic coding skills and a reasonable knowledge of how the markets work can get into rule based trading. Today, with many stockbrokers making easy API solutions available, it’s getting easier for the average individual to practice rule based trading strategies.
Simply put, rule based trading is a kind of trading system that relies on algorithms or mathematical rules to execute trades within a set of predetermined instructions. HFT is a trading strategy that makes use of powerful computers to execute a huge volume of orders in fractions of seconds. So, HFT is a kind of rule-based trading.
A rules based trading system can be extremely beneficial in markets where the prices of assets fluctuate frequently. So, it can be useful in any financial market that has this characteristic feature. This includes the stock market and the currency or forex market, among others.
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