Last Updated on 10 February, 2024 by Rejaul Karim
Pros and Cons of Algo Trading
What is Algo Trading?
Trading, as a profession, requires a lot of patience, dedication, and resilience. The traders need to remain highly concentrated on their trades and must not let their minds wander away. However, all this is easier said than done. Each trader knows that he must not lose his calm and the concentration, yet on numerous occasions, the traders get affected by the emotional and psychological factors and make decisions that should not have been made. These unavoidable and human errors can now be taken care of with the advent of technology. Algo trading serves just the same purpose.
Algo trading or algorithmic trading is the mechanism in which computer-generated algorithms are used to execute trades, instead of humans. Trades are made on the basis of a set of pre-defined rules. The trading instructions are programmed into the trading software in the form of algorithms, with reference to variables like time, volume and price. In turn, the computer makes the trade according to the instructions given to it. This makes algo trading quite precise, well-executed, well-timed, and free from most possible human errors.
Levels of Human Intervention in Algo Trading
The algorithms can be created to have either a minimum or no human intervention. Such algorithms are known as zero-touch algorithms. These programs are pre-entered into the trading software, and the trades are executed as soon as an opportunity is observed. The entire process occurs immediately, without any human intervention or control.
On the other hand, the other method of algo trading involves more human intervention. It is called Application Programming Interfaces (API). In this case, the traders choose the strategy that they want to implement in a scenario. The program is, then, instructed accordingly and the trade gets executed based on the information obtained through the API.
How Does Algo Trading Work?
Algo trading is an innovative method of trading that uses algorithms as a pre-defined set of instructions. These algorithms or instructions are run by the system to obtain a particular output. Buy and sell signals are received by the program and, based on the signals, the orders are placed and executed.
Algo trading works quite efficiently as the processes are not affected by the natural inefficiencies. The traders do not have to remain glued to their computer screens. When the preset criteria are met, the algorithm detects it automatically and sends buy or sell signals to the trader. The trader, thus, does not have to remain involved with the mundane parts and plays a significant role only in the important, strategy-creation step of the entire pro
What are the steps to be followed for Algo Trading?
The steps to be followed for algo trading include the following:
- Formulation of the Strategy: The most significant step for algo trading is to have the suitable strategy in place. The winning or losing potential of a trade is largely affected by the efficiency of the strategy. The traders may choose conventional strategies like mean reversal strategy or arbitrage strategy, or they may develop a strategy specific to their requirements.
- Automation of the Algorithm: The formulated strategy, then, needs to be turned into an algorithm. The algorithm is then automated and approved by the authorities. Once the strategy is vetted by the exchange and other regulatory authorities, it is good to get implemented.
- Developing or acquiring the trading software and feeds: Another significant requirement for algo trading is an advanced trading software. Traders can either build software of their own or buy the prebuilt ones like Tradestation, Multicharts, Omnesys NEST, Presto ATS or Meta Trader, to name a few.
- Perform the Trade: After the formulation of the strategy, automation of the algorithm and setting up of the infrastructure, the difficult part is almost over. The trader only needs to wait for trading signals generated by the algorithm, and respond to them.
What are the Pros of Algo Trading?
Algo trading has a wide array of benefits over the traditional methods of trading. The pros of algorithmic trading are listed below.
- Increased Speed: One of the most significant advantages of algo trading is the speed it offers. The algorithms have the capability to analyze a variety of parameters and technical indicators in a split second and execute the trade immediately. The increased speed becomes very important as the price movements can be captured by the traders as soon as they occur.
- More Accuracy: Another significant benefit of algo trading is that there is minimum human intervention. This means that the possibility of errors goes down drastically. The algos are checked and rechecked, and they do not get affected by the human errors. It is possible for a trader to make an error and analyze the technical indicators incorrectly, however, the computer programs do not make such mistakes in ideal scenarios. Thus, the trades get executed with maximum accuracy.
- Decreased Cost: Algo trading enables the execution of large volumes of trade in a short period of time. Due to this, multiple trades are processed and the transaction costs become reduced.
- Minimization of human emotions: The most significant pro of algorithmic trading is the minimization of human emotions. The strategies are pre-formulated and there is no room for the traders to get affected by their emotions. Once the pre-required objectives are met, the trade gets executed automatically, and the trader does not have the option of rethinking and questioning the trade. Algo trading keeps both under-trading and over-trading in control. The psychological elements are eliminated from the trade and there is no room for deviation from the initial strategies.
- Increased market volumes: With the help of algo trading, large volumes of shares can be bought and sold within a fraction of seconds. As a result, the overall volume and liquidity of the market get increased and the trading process becomes more streamlined and systematic.
- Ability to Backtest: The new algorithms created are first backtested using historical data. This helps to test whether the strategy will work or not. Based on the results of the backtest, the strategy can be modified and fine-tuned to fit the requirements of the trader. The strategy is made viable, and all rules are absolute with no room for interpretation.
- Improved Order Entry Speed: Algo trading processes the trades automatically. As soon as the trade criteria are met, the algorithm responds to the market change and generates orders. Entry and exit speed are extremely critical to the process of trading. A delay of even a couple of seconds can lead to losses. Therefore, better speed of entry and exit helps the traders in capturing the price movements at the exact point.
- Diversification: Algo trading uses algorithms and computers. Therefore, the process of executing multiple trades at the same time and multiple strategies at the same time becomes fairly easy. This would not have been possible humanly. The trading opportunities can be scanned over a range of markets, assets and instruments and orders are executed simultaneously. This leads to diversification which is very challenging in the absence of automation and algorithms.
- Preservation of discipline and consistency: As is commonly said, the most difficult aspect of trading is to plan the trade and trade the plan. Even when the traders have formulated their strategies, it becomes difficult to adhere to one’s plans due to the volatility in the markets. Algo trading deals with the volatility of the market and helps the traders remain consistent and disciplined in spite of the ups and downs. The rationality of the strategy remains upheld and does not get derailed due to the effect of impulses like fear and greed.
- Automation of the asset selection process: Overall, with the help of algo trading, the entire process of asset selection, order execution, and entry and exit becomes systematic. It becomes a step-by-step execution of instructions. This makes the process of trading quite objective and streamlined.
What are the Cons of Algo Trading?
Algo trading boasts of huge advantages. However, there are certain downfalls that the traders need to be aware of. The process of trading becomes too much dependent on the technology, and any failure in technology stops the wheels. Some of the cons of algo trading are described below.
- Dependence on Technology: The biggest con of algo trading is its immense dependence on technology. The trade orders, in many cases, reside on the computer, and not on the server. This means that if the internet connection is lost, the order will not be sent for execution. This fails the entire ideology of algo trading. In such cases, the traders miss out on the opportunities and may end up losing money. There are major systemic problems with algo trading that may also lead to huge flash crashes of the entire market.
- Loss of Human Control: Algo trading is completely automated. The humans are not left with the room for making any discretionary choices. Even if a trader realizes before the execution of the order that the strategy will not work in the particular scenario, he does not have the control to abandon the program and stop the trade. Even if the program runs in a direction that the trader does not want to, there is no way to stop it and control the losses.
- Need for Constant Monitoring: The ideal picture of algo trading is that the programs are preset and the trader can be away from his computer for long periods of time. However, the reality is not the same. The trader still needs to monitor the system to look for potential mechanical issues like connectivity, power losses etc. The strategies are integrated into the servers, yet they need to be monitored to ensure successful execution. The algorithms also need to be monitored to ensure that there are no missing orders, duplicate orders, or wrong orders. However, do not be concerned that you cannot be away from home. With the help of a smartphone and an internet subscription, you can check your servers once every few hours to ensure that everything runs smoothly!
- Need to Know the Programming Process: Algo trading requires for the traders to develop the algorithms. Not all investors are technically skilled. Therefore, they may either need to learn new processes or hire someone. The need for technical know-how makes algo trading quite complicated for the general public.
- Risk of Over-Optimization: It is highly probable that the strategies formulated on paper may not turn out to be successful and effective during live trading. This is called over-optimization, wherein the trading plan becomes unreliable in live markets. Despite strategies being built on historical data, there is a large possibility of the strategy failing as soon as it goes live, if the right methods are not employed!
- Requirement of Resources: Algo trading helps in the reduction of the transaction costs, however, it also adds on a lot of expenditure. The traders need to be equipped with high-end resources, must have an access to the server and must develop the algorithms using costly technology. Another big expense is the cost of data feeds that help in formulating intraday strategies.
- Regulations: Another con of algo trading is that it is subject to a lot of regulations. The regulatory bodies of different countries have not been able to reach a consensus on whether algo trading should be legal or not. There are many restrictions on algorithmic trading, and they must be dealt with before making a decision to start.
- Not all strategies can be automated: There are some excellent strategies that are almost sure-shot. However, all strategies cannot be automated and converted into an algorithm. So, the use of such strategies is not possible in algo trading. This eliminates the probability of making more money by using certain successful strategies, just because they cannot be automated.
- Short life span of the algorithms: Almost 98% of the algorithms have a very short lifespan. They work till they are suitable, and then suddenly stop working in the rapidly changing market. They are, then, required to be fixed or recreated. The formulation of algorithms and strategies is a continuous process and it consists of regular monitoring, improvement, and reinventing.
- Inability to Understand Irrational Markets: The bottom line is that algorithms are automated instructions and they cannot understand the situations and circumstances like human minds do. A trader has the ability to understand the irrational behavior of the market and respond accordingly. However, the algorithms understand perfect scenarios only. They lose control in the irrational markets and become erroneous under away-from-normal situations.
|PROS of Algo Trading
|CONS of Algo Trading
|Dependence on Technology
|Requirement of Resources
|Less Human Intervention
|Lack of Human Control
|Increased Market Volumes
|Short life span of algorithms
|Improved Order Entry and Exit Speed
|Need for Constant Monitoring
|Ability to Backtest
|Need to know the Programming Process
|More Discipline and Consistency
|Inability to understand Irrational Markets
|Automation of the Process
|All strategies cannot be automated
The Bottom Line
As a bottom line, algo trading is an effective and efficient method of trading. It has various advantages over the traditional methods of trading. Most importantly, algo trading helps to eliminate the effect of emotions from the trades. Emotions play a highly detrimental role in the trading process. The traders may become greedy for profits or scared of losses and may take decisions not meant to be taken. Algo trading helps to reduce the subjective parts of trading and ensures the decisions are made objectively.
At the same time, algo trading also helps to improve the market quality. The markets become broader and get more volumes and liquidity. The entire process becomes streamlined, systematic and disciplined.
However, algo trading has its own fair share of drawbacks as well. The costs to automate the strategies, build the algorithms and developing the trading software are high, and so are the infrastructure requirements. The brokers that support automated trading require larger capital base. Although this situation is gradually improving as many brokers are adopting the FIX protocol that allows them to execute trades directly with the market exchanges.
Additionally, algo trading is very dependent on technology and machines, and cannot withstand outages. The traders still need to monitor their trades and cannot leave the systems unattended. The algorithms could in worst case become erroneous and start making incorrect trades.
Therefore, like all the other forms of trading, the traders must be careful while creating the instruction algorithms. The traders must practice due diligence while applying the algorithms to the live scenarios.
What are the challenges associated with Algo Trading?
Challenges include dependence on technology, loss of human control, the need for constant monitoring, technical know-how requirements, risk of over-optimization, resource needs, regulatory controls, inability to automate all strategies, and the short lifespan of certain algorithms.
How does Algo Trading contribute to market quality improvement?
Algo trading follows pre-defined strategies, eliminating emotional decision-making. It helps traders remain consistent and disciplined, avoiding impulsive actions driven by fear or greed. Algo trading enhances market quality by increasing volumes and liquidity. The process becomes more streamlined, systematic, and disciplined, leading to overall market improvement.
What is the significance of backtesting in Algo Trading?
Backtesting involves testing algorithms using historical data to ensure their viability. It helps modify and fine-tune strategies based on past performance, making them more reliable for live trading. Also Algo Trading requires technical expertise to develop algorithms. Traders may need to learn new processes or hire experts to ensure effective implementation.