What is Algorithmic trading? Evolution, Advantages and challenges

Algorithmic trading: Algorithmic trading is a system of trading the securities in the stock market in which trading decisions take place by using advanced mathematical tools and complex algorithms. An algorithm is a computer program having a series of steps to solve a problem. It is a trading mechanism in which the technology dominates the decision making part leaving the human intelligence not to worry about the buying and selling decisions. Algorithmic trading is also called as Algo trading, black-box trading.

Evolution:

Algorithmic trading was developed for catering the needs of institutional traders who engage in trading of large amount of securities. These huge amounts of orders will be divided into smaller lots allowing the algorithms to execute the orders in fractions of a second. Most of the algorithmic tools are developed to get the best possible price.

The edge that an algorithmic trade offers:

The greatest advantage of algorithmic trading is that the decisions are made by the systems within milliseconds enabling the trader gain the advantage of any profit making opportunity resulting in the market much before a human intelligence (manual) can even find that. With the rapid advancements in the fields of machine learning and Artificial Intelligence (AI), algorithmic trading is increasingly becoming popular.

The systems are designed in such a way that a set of instructions that are fed into the pre-programmed algorithms would find and place a trade order to generate profits at a speed that is not possible in manual trading. These set of instructions are based on various parameters such as price of the security, quantity, timing etc.

Algorithmic trading involves huge initial investment to develop and acquire a technology that can execute the largely bulky transactions within fractions of a second. But the transactions costs in algo trading are much lower than the manual trading.

The possibility of making wrong decisions is very high in case of manual trade which may involve a variety of emotional and psychological factors at times. Unlike this, algo trading eliminates the risk of making bad trade decisions driven by human emotions as the computer programs follow the set of pre-programmed instructions to carry out the trade no matter what the investor’s instinct is in the market.

Challenges with Algorithmic trading:

  1. Though it looks like a luring trading method to make money effortlessly, the challenge is the volatility involved in algorithmic trading. During the times of chaotic conditions in the market such as announcement of open threats by US & DPRK, and the Kim Jong un’s unstable mood that can destabilize the global financial market with his nuclear programs, the algorithms will instantly follow the market conditions driving a large amount of bulky orders towards the prevailing chaos, eventually resulting in exaggerated market volatility.
  2. Transactions in algo trading take place at a very high speed. This means, a faulty bug or an erroneous instruction programmed to execute the orders can result in huge losses in a very short span.

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