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What are the advantages of algo trading?
The use of trading algorithms among investment firms has skyrocketed in recent years, but what exactly are the advantages of algo trading, and are the risks worth the rewards? Here we consider the pros and cons of algorithms to help investors decide if such a strategy is right for them.
What is algorithmic trading?
Algorithmic or ‘algo’ trading is a method that relies on advanced computer programmes to execute trade orders. The algorithms are essentially a set of instructions that a computer follows to make decisions in regards to buying and selling assets based on factors such as timing, volume and price.
The practice is often employed by institutional investors and brokerage firms as a way to cut trading costs, like transaction fees, and save time. However, there are other benefits that investors may seek to take advantage of to improve their chances of success in the market and boost gains.
The benefits of algorithmic trading
When used correctly, algorithms can be powerful trading tools with the ability to not only make essential decisions based on market behaviour but bolster the returns on trades while simultaneously minimising risk.
Some of the key advantages of algorithmic trading are:
Trading algorithms don’t have the capacity to get emotionally invested in the markets in the same way that humans do. Instead, an algorithm will react to predetermined market levels. Without the emotional attachment, trading firms and investors can rest assured that buy and sell decisions are made rationally and objectively – for some this may be the most valuable factor of algo trading
Perhaps a more obvious advantage of using algorithms as part of a trading strategy is the speed at which they can execute orders. This is particularly important for high-frequency trading, which relies on thousands of orders being made in a fraction of a second. It might not sound like much but if you’re competing for the best price on a stock, those seconds can have a big influence on returns, especially when trading large volumes
Reduced transaction costs
Algorithms can make trades automatically, which saves time and reduces transaction costs.
Minimise human error
No matter how good an investor or trader is and no matter how careful they are, human error is always a risk associated with manually executed trades. Computerised trading minimises that risk
Algo trading: risks and considerations
Despite the many benefits of using algorithms, it’s worth noting that algorithmic trading was widely blamed for the flash crash of 2010. Investors should be aware of the risks of using trading algorithms before venturing into an algo-reliant strategy.
Technology is great when it works, but there is always a risk of technological errors. If such a failure were to happen during intraday trading hours, the effects could prove expensive to investors. For this reason, it’s important to invest in sophisticated technology and run scrupulous tests before implementing it.
Since speed is such an important factor to the profitability of many algo trading strategies, any delays to the execution of orders could prove costly
By their very nature, trading algorithms are complex, which is why it’s important that algo traders have an understanding of computer programming. The more complex an algorithm is, the more rigorous the backtesting will need to be before an algorithm can go live
Backtesting an algorithm is an important part of ensuring that an algorithm is fit for its purpose. However, the process of assessing a trading algorithm isn’t straightforward and there are plenty of challenges to overcome. Investors planning to move into algo trading should ensure they have the ability and the infrastructure to effectively backtest an algorithm. Investors will likely need access to sufficient historical data too in order to effectively backtest their algorithms
Investors will have to decide for themselves whether algo trading is right for them. Although it’s clearly a profitable strategy that’s worked for many investment funds, there are many key factors that should be taken into consideration. It’s imperative that algorithms are also appropriately backtested before being used in a live market.
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