Algorithm Trading, also called Automated Trading, Black-Box Trading or Algo-Trading is the use of electronic platforms for entering trading orders. It is driven by algorithms which use vast volumes of data that modern trading operations generate and evaluate it in ways and at speeds that humans cannot. It focuses on speed and gains leverage by cutting out the human factor from decision-making. The algorithms used execute pre-programmed trading instructions whose variables may include timing, price or quantity of the order. It is used widely by investment banks, pension funds and mutual funds.
The advantages of Algorithm Trading include:
- It gives better market insights and generates additional profits
- They can be programmed to have better sense than some human traders
- It minimizes emotions throughout the trading process and thus makes it easier to stick to the plan
- It helps preserve discipline even in volatile markets
- It improves order entry speed
The disadvantages of Algorithm trading are as follows:
- Humans cannot evaluate a breaking story or cancel trades as fast as Algorithm Trading. This gives credence to the idea that markets are no longer for mere mortals, but only for specialists who can access heavy-duty computing and bulk data.
- Computers may relinquish and regain positions several times per second, creating “hot potato” volumes in trading.
- Its mechanics are poorly understood since algo traders are generally tight-lipped about technicals.
- Trading machines usually react to uncertainty conservatively, dropping their positions and exiting the market. The exit of machines in a flock can exacerbate the negative human sentiment prevailing in markets.
- First-come-first-served trading disproportionately advantages firms that invest in faster computers and thicker data pipes, encouraging a digital arms race. Further, firms that are physically located closer to markets also have a slight edge in the transmission time of orders.
- It has been criticized as systems that look great on paper, but perform terribly in live markets.
- It requires monitoring and cannot be left on its own.
Though it is a sophisticated method of trading, yet it is not infallible. Failures are possible in this system too.
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