Algorithmic trading has become incredibly popular over the past decade or so, with dozens of major services offering trading algorithm services to mainstream consumers. This system relies on an algorithm to make buying and selling decisions in the stock market, often on behalf of consumers; if you subscribe to one of these services, you’ll hand over a chunk of capital, and allow the algorithm to use your money to invest as it sees fit.
To some, this seems like a genius breakthrough that takes the guesswork out of investing. To others, this is a scary application of technology with unseen consequences.
Should you trust an algorithmic trading platform to handle your money? Or outperform the market?
The Basics of Algorithmic Trading
Before you can decide whether you trust a new technology, you need to have a basic understanding of how it works. First, an app must pull real-time stock market data, both for the algorithm to use and for end users to see. Typically, this is done using a stock API. A good stock API makes it possible for an application to pull accurate, reliable data consistently—either from a single exchange or aggregated from multiple exchanges.
From there, the trading system makes use of an algorithm. Algorithms are just sets of rules for a machine to follow. For example, a stock trading algorithm might be designed to purchase 100 shares of a given stock if its 50-day moving average falls below a certain threshold, and sell 100 shares of that stock if its 50-day moving average rises above a different threshold. Hypothetically, these rules would allow you to apply a strategy consistently and see better-than-average returns.
Key Advantages of Algorithmic Trading
There are some good reasons to “trust” algorithmic trading, and potentially use it for your own investing strategy:
- Automation. Algorithmic trades are completely automated, which is mostly a good thing. Rather than committing all your trades manually, or relying on alerts to guide you, the algorithm will make decisions on your behalf. That means you can spend less time agonizing over decisions and manually inputting trades.
- Lack of human biases and emotions. Even the best, calmest investors sometimes deviate from their stated strategy because of human biases and emotions. They get scared or greedy, and end up making a major mistake. With a programmed algorithm, you don’t have to worry about these forms of clouded judgment. Instead, you can rest assured that the algorithm will perform everything with no bias.
- Lower transaction costs. Algorithmic trading also typically offers lower transaction costs. Because you’re not relying on a specific platform, nor are you relying on a human broker, you can trade faster, more conveniently, and less expensively.
- Strategic flexibility. Best of all, algorithmic trading offers strategic flexibility. There’s no one set of rules that all algorithms follow; instead, you can choose and customize different types of algorithms for different needs. For example, you might choose an algorithm that deliberately seeks high-risk, high-reward decisions, or you could choose one that mostly employs a buy-and-hold strategy. Because of this, it’s practically impossible to say that all trading algorithms are good or bad; much of their success depends on what they’re trying to achieve.
The Downsides of Algorithmic Trading
However, there are some downsides worth considering:
- Firm execution. Human biases and emotions often get in the way of intelligent, strategic decision making. However, intuition and creative thinking can be advantageous. If you rely on a trading algorithm to make all your decisions for you, you’ll be locked into a specific set of allowable actions—and you won’t have much wiggle room.
- Flash crashes (and more). Speaking broadly, excessive use of algorithms can result in market volatility, as evidenced by the 2010 flash crash and subsequent flash crashes. If algorithms are all making similar decisions and trading significant volumes, they can effectively manipulate market prices (unintentionally), resulting in massive, unjustified spikes. There are now safeguards in place for this, including more refined algorithms and built-in stock market “circuit breakers” to prevent losses that are too heavy, but it’s still worth considering.
- User fees. Finally, most algorithmic trading companies only offer services in exchange for an ongoing fee—usually a percentage of whatever you’ve gained using their algorithms. While you might see a higher return using an algorithm than if you simply made decisions on your own, at least some of the difference will be eaten up by these fees.
Algorithmic trading isn’t inherently or universally better or worse than other forms of investing. It’s a relatively new technology that offers distinct benefits, but also some drawbacks worth considering. Before getting involved in algorithmic trading, do your due diligence, and make sure you understand all the potential advantages and risks you face before proceeding.