This principle may be new to some investors and yet, many feel that this will be the financial tool of the very near future.
However, there are others who believe that such systems can be dangerous if they are not properly employed.
To appreciate the benefits and drawbacks of algorithmic trading, we need to examine this concept in a bit more detail before weighing its efficacy in today’s markets.
Algorithmic Trading Defined
The theory behind algorithmic trading is actually quite simple. It is the algorithms utilized that can become complicated. From a basic standpoint, this type of trading implements automated software to attempt to successfully predict the outcome of a specific trade or asset (1). Some of the metrics that are often taken into account include:
- The time of the day.
- The trading volume.
- Political events.
- The price of the underlying asset.
- The movement of specific indices.
- Late-breaking news and market sentiment.
Some would term these fields “big data”, as they incorporate numerous variables to come to a conclusion. Thanks to this type of quantitative analysis, a sizable portion of what could otherwise be considered human guesswork is taken out of the equation. Now that we have developed a basic comprehension of algorithmic trading, what are the benefits and potential pitfalls of such a system?
The Advantages of an Algorithmic Trading System
Most traders will cite speed as the primary advantage offered by this method. This could be therefore be an ideal option for those who are looking to capitalize upon short-term movements (such as those often associated with Forex pairs).
A second aspect worth mentioning is the fact that it would be nearly impossible to analyse the sheer amount of data that an algorithm can peruse. Even if all of these metrics were manually followed, it is likely that the investor would miss countless other valuable opportunities. So, algorithms tend to take the leg work out of the scenario. This leaves the trader free to follow other assets and to take multiple positions if desired.
Finally, algorithmic trading is generally included as a portion of standard online investment packages. So, there is no additional charge for its implementation within an existing strategy. As the use of AI (artificial intelligence) is continuing to evolve, we should expect such systems to become even more commonplace.
The Potential Drawbacks of Online Algorithmic Trading
It would be irresponsible to fail to mention that there can also be a few disadvantages to this approach. First of all, no algorithm is perfect. Predictions can be incorrect and if these are followed, there is always a chance that an investor could lose money.
Secondly, there have been times when automated trades have cause massive market shifts. Of course, this is taken from a macroscopic viewpoint. The most recent example of this was the “flash crash” within the currency markets that occurred in early October 2016. At one point, the value of the pound in relation to the dollar fell as much as 9 per cent (2) during a single trading session.
The final fault lies within the actions of the investors themselves. It is thought that on average, algorithmic predictions are accurate approximately 70 per cent of the time. A 30 per cent margin leaves quite a lot of room for error. However, some traders will rely solely upon the automated signals as opposed to incorporating them into their existing strategy. This can naturally cause problems and mounting losses over time.
A Reasonable Compromise
Are algorithmic trading platforms inherently good or bad? The truth is that they are likely somewhere in the middle of these two polar opposites. Any such software should be utilized in combination with advanced trading tools and cutting-edge investment software, such as can be found at CMC Markets. No investment method is infallible and while algorithmic operations may be still somewhat new to the marketplace, the fact of the matter is that they are undoubtedly here to stay.
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