As a trader in the capital markets, you proceed to place your trades based on a trading approach that best suits you. For instance, you may be a swing trader who identifies setups well poised for potential breakouts. However, just because your strategy aligns with your thought-process and is making you money, that does not make it flawless. A swing trader who is on the lookout for a setup that is on the cusp of breaking out, is forced to wait patiently if the price is trapped in a consolidation zone.
Regardless of how fine-tuned the method or strategy is, there will always be both pros and cons to adopting it. Many may hold the impression that the previous statement does not apply to one trading style — Algo trading. However, like any other approach, there are advantages and disadvantages to algo trading as well.
What is Algo Trading?
Algorithmic trading, also called "algo trading," is a trading method wherein trades are carried out by computer generated algorithms. To put it another way, a set of predefined trading rules is entered into a trading software in the form of a computer algorithm. The software then executes trades based on the instructions it receives. The instructions that are coded into a computer programming language are composed of variables like time, volume, price, etc. Since algo trading is executed by trading software, it is free from almost all sorts of human interventions.
Therefore, in the case of algo trading, the majority of human resources are directed towards constructing the set of trading rules, converting them into computer code, and testing them. Professionals from finance, statics, and programing backgrounds contribute to performing the aforementioned task. Once they get the algorithm up and running, the computer will execute trades when the predefined conditions are met. However, some algo trading software may require more human intervention because it requires humans to input instructions frequently. Now let us look at the pros and cons of algorithmic trading.
What are the Pros of Algo Trading
As trades are executed by a computer program, algo trading has a number of advantages over traditional online trading strategies. So, let us quickly read through some of its major benefits.
- Instant Speeds Algorithms are capable of executing trades at instantaneous speeds—within milliseconds and microseconds. A human trading with their motor organs will never be able to trade at the speed of the algo software. It is impossible for us humans to place trades at such speeds using our bare hands. There, algorithmic traders are able to capitalise on even the tiniest fluctuations in the price of securities. At the same time, algorithms can even analyse a chart within a split second.
- High Accuracy Since algo trading does not require human intervention to make buying or selling decisions, algo trades have a lot higher accuracy. They are free of all human-made errors. For example, the algorithm will not misenter the quantity of units meant to be traded. It will always enter the correct number of zeros and not carelessly trade 100 units instead of 1000.
- Free of Emotional Interventions As a trader using traditional online trading strategies, no matter which strategy you use, everything can fall apart if your emotions get involved. Our emotions can derail the strategy and disrupt discipline, resulting in unfavourable outcomes. However, algorithmic trading solves this major problem, as a computer programme is devoid of emotions . If the predefined conditions are met, the computer programme will execute the trade automatically. In this case, second thoughts cannot prevent the trader from performing or refraining from performing actions that they will later regret. So, in a way, it also helps keep overtrading and undertrading under control.
- Decreased Cost in the Long Run The initial cost to set up the algo trading infrastructure may seem costly, however, once the system is up and running, it proves to be a cost-saver in the long run. Multiple trades are processed, and transaction costs are reduced, because algo trading allows for the execution of large volumes of trades in a short period of time.
- Diversification Since the algorithm and computer programme are able to scan multiple charts in a few minutes, they can also be programmed to execute multiple trades at the same time. And this is not limited to a single exchange or geography, as the computer can scan charts and execute trades in stock markets around the world.
- High Volumes Algo trading allows traders to trade large volumes of securities within seconds. This helps with maintaining high liquidity in the markets.
What are the Cons of Algo Trading
Now that you have read through the advantages of algo trading, it is time to look at the disadvantages. Despite having high accuracy and speeds and being devoid of emotions, algorithmic trading does have some noteworthy disadvantages.
- Reliance on Technology Technology has helped evolve algo trading to what it is today, but a lack thereof is not its biggest disadvantage. If you do not have the technological infrastructure or lose access to technology, you will be unable to take advantage of algo trading. In some cases, a disruption in your internet connection will result in your order not being executed if the date is stored locally.
- High Initial Expenses It is true that in the long run, algorithmic trading proves to be cost-effective if you intend on placing multiple trade orders daily. However, the initial cost of setting up the algo trading infrastructure is costly. Algo traders desire to have the fastest computers that are capable of placing trades at instantaneous speeds.
- Need for Programming Skills Besides the high initial cost, you will also require programming knowledge to write the algorithm. For that, you must know a computer language like C++ or Python. If not, then you will have to hire a professional to write the algorithm for you.
- Need for Constant Advancements The competition among institutions in the algo trading space is intense. So, to have an edge over other algo traders, you have to constantly keep upgrading your algo trading strategy. At the same time, algorithms also are only effective until market conditions are suitables. But with ever dynamic markets, there is a need to continuously improve upon the algorithm. Hence, an algo trader may not be pushing buttons to place trades, but they still have to constantly monitor markets.
- Stringent Regulations Lastly, algo trading is subject to a number of regulations. The regulation bodies of a few countries still have not been able to reach a consensus on whether algo trading should be legal or not. So, there is always a chance the regulatory body may impose new algo trading rules or ban it completely.
Conclusion
Now that you have read through the pros and cons of algo trading, the bottom line is that algo trading is a very effective method of trading. However, it is heavily dependent on technology and programming skills. That said, it helps eliminate the elements of fear and greed from the equation, which helps traders stay true to their strategies. However, it goes without saying that algo traders must still create algorithms diligently. If the algorithm is poorly designed, no money will be made.