Algorithmic trading, which is popularly known as algo trading, was by and large used by institutional investors. However, now many broking houses are offering algo trading feature to retail or individual investors.
Let us discuss the advantages of such trading and what are the risks associated with it.
What is algo trading?
It is nothing but the process of using computers to follow a specific set of defined instructions for placing an order or trade to generate profit which is otherwise impossible for a human. In algo trading, human intervention is very minimal and the system identifies on its own, any profit-making opportunities arising in the market even before the human trader can identify the same. It is being used by large institutional investors who deal in large number of shares. It has become increasingly popular in the last few years and is attracting the attention of many retail investors who invest in stock markets.
Mechanics of algo trading
For instance, as an investor one can use the following two simple buy / sell criteria. (a) Buy 100 shares of ABC company, whenever its 50-day moving average goes above the 100-day moving average (b) Sell shares of XYZ company, whenever its 50-day moving average goes below the 100-day moving average. So, using the above two simple instructions a computer programme can be written that will automatically track the share price including moving average indicators and place buy and sell orders whenever the rules are met. So, there is no need for the investor to monitor the live prices or graphs or even place orders. The algorithm performs the investor’s work more efficiently.
Algo trading has several advantages. Fast trade execution, accuracy, the ability to discard emotions while trading and hundred per cent compliance with the decided trading strategy are some of the advantages.
Rationale for algo trading
An individual investor can use algo trading because it multiplies his profitable trade. If a particular trading is profitable for you, you should be able to increase the number of profitable trades in order to earn more. In trading, losses and wins happen simultaneously.
You will be profitable only when your wins compensates for your losses enough so as to account for your efforts and costs.
Algorithmic trading is a technique to do the same.
Another reason which goes in favour of algo trading is that by and large retail traders are trading on gut feelings based on the market movements. Sometimes, the gut feeling proves to be wrong, mostly when the market has a mixture of greed and fear. When the markets are in the bear grip, many amateur traders sell quickly as they fear a further crash and wish to protect their capital at least. Algorithmic trading follows pre-decided entry-exit rules which prevent such emotional trading and hence avoidable losses.
Many stock broking houses allow their clients to use their own algo trading strategies, some brokerage firms even allow their retail clients to select from the algo trading schemes that are pre-programmed by the brokerage itself.
However, the general feeling is that even if retail investors get to use some algo trading facilities they may not be able to gain as much as the institutional clients who have been using higher order tools such as high frequency trading, arbitrage, etc.
To conclude, any trading strategy whether algo trading, high frequency trading or arbitrage, has its own merits and limitations. If you as an investor want to become a trader, use them wisely.
The writer is professor, School of Commerce and Management, Central University of Tamil Nadu