Algorithmic trading or algo-trading as it is commonly referred to as, is the process of using computer programming that follows a distinct pattern of instructions for placing trades. It is also called Quantitative or Quant Trading. Algo Trading helps to generate profits at speeds unattainable by any human. The rules that form this pattern are generally based on timing, price, and quantity or if you want you can specify any mathematical model. Algo-trading makes the market more liquid, and helps trading to be extremely systematic for a trader.
How does a trader benefit from Algo-Trading?
If traders uses this technique, they will benefit in the following ways:
If you decide to use algo-trading, there are a lot of advantages that you can reap benefits from:
No Emotions: When you’re using an automated system like algo-trading, it will minimize all emotions throughout the trades. Now, if your emotions are in check, as a trader you will automatically be able to stick to your strategy. Every trade will be executed perfectly once your trade rules are met and there is not a single moment of hesitation.
Data: Traders can actually design their own rules for algo-trading. What they can also do is use those set of rules and test them on historical data before they start using it during a session at the stock market. Back-testing will allow traders to tweak their rules accordingly.
Discipline: Due to these set of rules, and also due to the automated nature of execution, there exists a discipline during volatile markets. Often emotions gets the better of a trader during a volatile market and that might lead to greater losses.
Consistency: With this automated technique in place, you will be able to achieve consistency in your trades because the algorithm will follow your set of rules without fail. However you have to tweak it constantly because no method is foolproof.
Diversified Trading: This will permit you to trade multiple accounts and use various strategies at one single point of time. It will allow you to spread your risks over various investments and create a hedge or a safety net. It will be extremely easy for a computer to pull this off than a human trying to carry this out.
A few disadvantages that you will face if you use algo-trading (and how you can avoid them):
System Failure: At a glance, the process of trading through computers might appear simple but there is more to it than meets the eye. You have to set up a software, set up all the rules and then you have to watch it trade, but there are also the issue of connectivity. If your computer loses the internet connection, then a trade may not be executed. Then there will arise discrepancies in your strategy because of these issues. You should slowly increase trade sizes and refine the process constantly so the chances of mechanical failure are eradicated completely.
Monitoring: Even though the process is automated, but you cannot leave it alone and let it be. It needs monitoring, especially because of disadvantage #1. You cannot afford to lose potential trades due to connectivity issue or a power loss or even a system crash. But if you monitor how your system is performing, you will be able to resolve all these issues.
Over-Optimization: Don’t back-test your product too much and end up with a system that is great on paper but performs terribly when trading live. That will not suit your purpose. Do not try to tweak it too much to achieve success based on historical data. Remember you are trading in the present and not in the past. You cannot have a 100% profitable plan.
Algo-trading does have its advantages but while using it or thinking of using it, you should keep in mind its disadvantages, or else you will lose more trades. Server-based platforms might prove to be more efficient and might lead to fewer mechanical failures.