Algorithmic trading is the technique which has come into existence in the past few years only, it is used in the context of trading in financial markets like equity, derivatives and commodities. It refers to that technique using which the traders or investors make use of software programs to do automatic or programmed trading. In algorithmic trading entry point and exit points of trade is fixed so for example if trader has fed into the system then when the price of Microsoft stock reaches $100 then 10000 Microsoft stock will be sold and if it reaches $95 then 10000 Microsoft stock will be bought then trader does not need to monitor the stock price of Microsoft as the program will do the trading according to instructions fed into the system. In order to understand this concept better let’s look at some of the advantages and disadvantages of algorithmic trading –
Advantages of Algorithmic Trading
- The biggest advantage of algorithmic trading is that it removes the emotional side of the trader or investor because all trades are executed according to computer programs. Greed and fear are perhaps the biggest challenges for both traders as well as the investor in case of financial markets and it is due to greed and fear that majority of traders and investors lose money as they take decisions on emotions and algorithmic trading by removing the emotional aspect reduce the chance of human emotions induced mistakes.
- Another advantage of algorithmic trading is that it helps in maintaining discipline as far as traders are concerned because entry and exit rules are predefined and the chances of trader violating the rule are next to nil in case of algorithmic trading. In stock markets discipline is simple to say but difficult to implement and the majority of traders lose money because of lack of discipline in their trading pattern and algorithmic trading addresses that problem.
- Another advantage of algorithmic trading is the speed with which these programs executes orders, in stock markets where every second counts the speed factor makes algorithmic trading a favored option among trader fraternity.
Disadvantages of Algorithmic Trading
- The biggest disadvantage of algorithmic trading is that algorithm trading is not 100 percent accurate and it has the scope of failing in the sense that one glitch in the program can trigger many orders which in turn can lead to dramatic rise of fall in the price stock which in turn can lead to sudden downfall or flash crash in the stock market leading to panic and volatility.
- Since it requires the use of the program and technical expertise it can be done by only those people who have the required knowledge and expertise and hence it not everybody’s cup of tea which in turn does not provide level playing field to all participants in the stock market.
- Another limitation of algorithmic trading is that algorithmic trading is not universal or in simple words one algorithm cannot be applied to every situation and hence one needs to constantly monitor or alter the algorithm and therefore one cannot depend on one algorithm for doing all types of traders if or she wants to profit from algorithmic trading.
As one can see from the above that algorithmic trading has both pros and cons and it can be compared to an F1 racing car, just like F1 racing car look great when it is running at full speed on racing track but slightest error can prove to be fatal for the driver. In the same way algorithmic trading looks fine until it is running smoothly the moment any error happens it can be disastrous for the trader. Hence trader should take benefit from algorithmic trading but at the same should exercise proper care while doing algorithmic trading.