Algorithmic Trading: Meaning, Advantages and Disadvantages (2024)

In this article, we will discuss

• What is Algorithmic Trading?
• Example of Algorithm Trading
• Advantages of Algorithmic Trading
• Disadvantages of Algorithmic Trading
• Conclusion
• FAQs

With the advancement of technology, when everything has gone online, so has trading. It has become easier to execute trades, and the speed has greatly increased. It has definitely made it easy for everyone to trade from the comfort of their own homes.

However, it has also forced us to make every minute count. The rapid pace of trading software is not easy for a human being to match. This is where algorithmic trading comes into play.

In this blog, we will discuss the meaning of algorithmic trading and its benefits and advantages so that you can use it to maximise your profits.

What is Algorithmic Trading?

Also known as black box trading or automated trading, it is a type of trading based on computer programs. The programme is used to execute trades based on a set of pre-defined instructions or rules fed into it.

When these conditions of the programme are met, it executes the order at a speed that is not possible for any human being to match. This algorithm can be based on numerous different inputs such as price, timing, quantity or other metrics.

You can use Algo trading after creating an algorithm that allows users to buy and sell orders, but it would still require some level of human intervention. A trader needs to write certain codes so that the conditions are met for the programme to execute the order. No matter how refined your program is, you can’t make it fully automated as it is not permitted for retail traders.

Example of Algorithm Trading

Let’s see an example of it to understand algorithmic trading better.

Suppose a trader monitors different Daily Moving Averages (DMA) to determine whether they should execute a trade or not. Their decision is always based on whether the share price ends above or below the DMA.

Now, if the same trader was using software decked with algo trading, they wouldn’t have to manually go through the entire procedure. With automated trading, all they will have to do is instruct the system on what action to take if the price rises above a specified DMA.

Even if you use any other metric, you will just need to instruct the system on what metric to check and what action to take after that.

To better understand it, let's assume the trader uses a 7-day DMA for security, and the result of this metric is a price point of ₹115.65. Now, as the next step, they instruct the computer program to buy 100 lots of stock when the price crosses this DMA.

If you were a human being, it might take you a minute or two to execute the trade once the price crosses ₹115.65. However, with algorithmic trading, it will take the system just a few seconds, and it will execute the trade in the blink of an eye.

Advantages of Algorithmic Trading

Some of the major advantages of using algorithmic trading include:

• It allows you to execute trades without human errors. As a human trader, you might sometimes end up giving the wrong input and enter a complicated position. However, with algo trading, you can expect the most accurate trading executions.
• There can sometimes be a significant price fluctuation between the time you decide to enter a trade and the time you execute it. However, automated trading eliminates this possibility because it executes a trade as soon as the requirements are met. This makes the trade placements instant and highly accurate. Accurately timed trades evade price fluctuations as far as possible.
• Even if you fail to get the trade at the very exact price, you can still get it at the best possible price, which human traders will fail to do most often.
• Use of algo trading strategies and methodology has eliminated several intermediaries from the system. Every intermediary involved charges a percentage of the cost as a commission. With their elimination, it has significantly reduced the costs of a trade for an investor.
• If you use multiple metrics before executing a trade, in the absence of automated trade, you will be forced to check each of these metrics manually and subsequently. By the time you make sure all the parameters are met, you might lose the opportunity to enter a trade. However, with black box trading, the system automatically checks all the requirements simultaneously, thus reducing the time by manifolds.
• You can also backtest your algo trading strategies before entering an actual trade. It can be done by using historical data and also real-time information. It will give you an idea if your strategy is viable or if you need to make changes.
• It might sometimes happen when executing a trade your emotions come in the way and you change your strategy impulsively. For example, you see your profits rising and decide to keep the position open even after you have attained your target profit. After five minutes, you see all your capital swiped away.

You can regulate such emotions better using algorithmic trading. When you instruct the computer program with a set of instructions, it won’t think of how you will feel and simply execute the orders. This helps you eliminate the negative impacts of human emotions from your trade.

Disadvantages of Algorithmic Trading

While algo trading has evolved the way we traders execute trades in a very positive manner, it also comes with its own disadvantages.

• Even the best algo trading strategies implement the use of historical data and mathematical calculations to predict the future price conditions of the market. However, these systems can fail in case when an unforeseen market circ*mstance arises. These situations are called black swan events and can lead algorithmic traders to suffer losses.
• The system relies entirely on the use of technology. Hence, if there is even a slight glitch in the system, the entire program of automation trade can crash. Such a crash can again lead to extremely heavy losses and disrupt the entire market.
• It might create disruption for traders who are not very tech-savvy. Frequent updates and changes in the technology of such trading can be hard to cope with. Additionally, if you do not understand the system well, you might end up taking an action that you didn’t want to take.
• The entire development and creation of the system of algorithmic trading is complicated, expensive and hard to build. In some cases, to cover the costs of such developments, traders may be charged fees that they may not want to pay.
• The system lacks a sense of human judgement. Hence, it shall act only as per the set of instructions that you give to it. Therefore, if you ever give an instruction that could lead to a loss-making trade, the system will execute it irrespective of what will happen next. Hence, despite it being automated, you still need to monitor it.
• If you ever need to implement a strategy or make customisations that the system doesn't understand yet, you will have to make it manually. This, in some way, fails the purpose of developing this system.

Conclusion

Algorithmic trading has revolutionised the way we execute trades. It has brought together the financial markets, the software, payment gateways, and so many other factors together on a single screen. You don't need to physically visit a stock exchange anymore to invest in the markets. However, it might still be confusing for traders who don't understand computer software much or are still learning the nuances of trading.

Frequently Asked Questions

Q1. What is High Frequency Trading?

Ans. High Frequency Trading or HFT is one of the most popular types of algo trading. It helps you place a large number of orders even if they have multiple conditions, and you place them on multiple markets.

Q2. Can every category of investor use algo trading?

Ans. Yes, every category of investor can use this trading system for different purposes. Hedge funds can use it to take opposite positions and hedge their investments. Institutional investors use it to buy large quantities of stock without creating an impact on the price of the quantity.

Q3. What are the different types of algorithmic trading strategies?

Ans. The different algorithmic trading strategies involve trend-following strategies, index fund rebalancing, and mathematical model-based strategies.

Q4. How can I start algorithmic trading?

Ans. You will have to first understand the market and learn to code. For this, you will need good knowledge of computers. Thereafter, start backtesting your strategy and then choose the right trading platform to trade live.

Q5. What is backtesting?

Ans. Backtesting is a method to see how your particular strategy would have performed in a particular market scenario. It is done by using historical data.

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