What Is Algorithmic Trading?
Also known as algo trading, algorithmic trading is a method of stock trading that uses intricate mathematical fashions and formulas to initiate high-pace, automated monetary transactions. The objective of algorithmic trading is to help buyers execute on specific financial strategies as shortly as doable to herald higher profits. While there are a number of key benefits to algorithmic trading, there are also some risks to consider.
How algorithmic trading works
An algorithm is a process or set of defined rules designed to hold out a sure process. Algorithmic trading makes use of laptop programs to trade at high speeds and quantity primarily based on a number of preset standards, resembling stock costs and particular market conditions.
For example, a trader would possibly use algorithmic trading to execute orders rapidly when a certain stock reaches or falls beneath a selected price. The algorithm might dictate how many shares to buy or sell based mostly on such conditions. Once a program is put in place, that trader can then sit back and calm down, knowing that trades will automatically take place as soon as these preset conditions are met.
Benefits of algorithmic trading
One major advantage of algorithmic trading is that it automates the trading process, making certain that orders are executed at what are deemed to be optimal shopping for or selling conditions. Because orders are placed instantly, buyers can relaxation assured that they won't miss out on key opportunities. Manual orders, by contrast, cannot come near mimicking the velocity of algorithmic trading. Additionally, because everything is done automatically by computer, human error is virtually taken out of the equation (assuming, of course, that the algorithm is developed appropriately).
Furthermore, algorithmic trading often limits or reduces transaction prices, thus permitting investors to retain even more of their profits. Finally, algorithmic trading eliminates the dangers of performing on emotion instead of logic, which traders are known to do.
Drawbacks of algorithmic trading
One major disadvantage of algorithmic trading is that one easy mistake can rapidly escalate in a major way. It is one thing for a trader to make a bad call and lose cash on a single transaction, but when you will have a faulty algorithm, the results could be downproper catastrophic. That is because a single algorithm can set off hundreds of transactions in a matter of minutes, and if something goes improper, tens of millions of dollars might be misplaced in that same time frame.
In truth, there have been multiple incidents of "flash crashes" on world markets ensuing from problems with algorithmic trading. For example, algorithmic trading was blamed for the "Flash Crash" of 2010, which led U.S. stock indexes to break down (although they rebounded within an hour), as well as an October 2016 crash that saw the British pound plunge toward its 31-yr-low in a single night.
Algorithmic trading has additionally been linked to significant market volatility. While quality management measures can assist forestall losses owing to poorly defined or coded algorithms, investors needs to be aware of the hazards of giving up management and letting computer systems do all of the work.
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