What Is Algorithmic Trading?
Also known as algo trading, algorithmic trading is a method of stock trading that makes use of intricate mathematical fashions and formulation to initiate high-velocity, automated financial transactions. The objective of algorithmic trading is to help traders execute on specific monetary strategies as shortly as doable to usher in higher profits. While there are a number of key benefits to algorithmic trading, there are additionally some risks to consider.
How algorithmic trading works
An algorithm is a process or set of defined rules designed to carry out a sure process. Algorithmic trading makes use of laptop programs to trade at high speeds and volume primarily based on a number of preset standards, corresponding to stock costs and specific market conditions.
For example, a trader would possibly use algorithmic trading to execute orders rapidly when a certain stock reaches or falls beneath a specific price. The algorithm might dictate how many shares to purchase or sell based on such conditions. Once a program is put in place, that trader can then sit back and relax, figuring out that trades will automatically take place as soon as these preset circumstances are met.
Benefits of algorithmic trading
One main advantage of algorithmic trading is that it automates the trading process, guaranteeing that orders are executed at what are deemed to be optimum shopping for or selling conditions. Because orders are placed instantly, investors can relaxation assured that they won't miss out on key opportunities. Handbook orders, in contrast, cannot come close to mimicking the velocity of algorithmic trading. Additionally, because everything is done automatically by pc, human error is virtually taken out of the equation (assuming, in fact, that the algorithm is developed appropriately).
Additionalmore, algorithmic trading typically limits or reduces transaction costs, thus permitting investors to retain even more of their profits. Finally, algorithmic trading eliminates the dangers of appearing on emotion instead of logic, which buyers are known to do.
Drawbacks of algorithmic trading
One main disadvantage of algorithmic trading is that one easy mistake can quickly escalate in a serious way. It is one thing for a trader to make a bad call and lose money on a single transaction, however when you have a faulty algorithm, the results can be downright catastrophic. That is because a single algorithm can trigger hundreds of transactions in a matter of minutes, and if something goes improper, hundreds of thousands of dollars can be lost in that very same time frame.
Actually, there have been multiple incidents of "flash crashes" on global markets resulting from problems with algorithmic trading. For instance, algorithmic trading was blamed for the "Flash Crash" of 2010, which led U.S. stock indexes to break down (though they rebounded within an hour), as well as an October 2016 crash that noticed the British pound plunge toward its 31-12 months-low in a single night.
Algorithmic trading has also been linked to significant market volatility. While quality control measures might help stop losses owing to poorly defined or coded algorithms, investors needs to be aware of the dangers of giving up management and letting computer systems do the entire work.
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