5 Big Risks of Algorithmic Trading

Estimated read time 5 min read

Algorithmic trading, also referred to as “algo”, utilizes computer programs to execute trades based on predefined algorithms that identify profit opportunities and execute trades.

However, these strategies can become vulnerable to technical glitches that lead to lost opportunities and financial losses – otherwise known as black swan events.

Algorithmic Trading

1. Dependence on Technology

Artificial Intelligence is steadily taking over our world. According to a University of Georgia study, people now trust computers more than fellow humans. This dependence extends into the stock market where traders and investors turn to Algo Trading software in order to make more profitable trades.

Trading using computer programs allows traders to execute trades quickly, often within milliseconds. Even the slightest delay could mean missed opportunities and financial losses for their investors.

Trading algorithms may also contain errors due to programming mistakes or inaccurate data inaccuracies, or over-optimization based on past performance, leading to their failure when applied in real markets.

Algo trading may offer significant profits, but it may not be suitable for everyone. Longer-term investors like pension funds, mutual funds and insurance companies find great value in algo trading as it allows them to purchase large volumes of stocks without disrupting the market with sudden investments of significant volume. Shorter term traders may benefit from using automated trade execution processes which improve efficiency while decreasing risks of slippage.

2. Market Impact

Algorithmic trading, more commonly referred to as black-box or high-frequency trading, uses computer programs with pre-determined algorithms in order to execute trades quickly and precisely – giving traders the ability to take advantage of fleeting market opportunities while preventing costly slippage.

But if an algorithm goes awry, the consequences can be catastrophic. A single error could spark hundreds of transactions that eat away at millions in seconds – an especially worrying prospect as algorithms become ever more complex and errors spread more easily throughout a network of systems.

Knight Capital’s 2012 demise was caused by a dormant code triggering millions of erroneous orders, costing the firm $460 million within minutes and ultimately forcing its closure. These failures highlight the necessity of developing a data-driven culture which supports transparent access and established methods of governance to limit technological risk; additionally, such a culture should foster flexible yet responsive research and development approaches to stay at the forefront of technological innovations.

3. Black Swan Events

Black swan events are unpredictable events that appear abruptly and cause dramatic impacts on financial markets. They tend to cause widespread panic in the market and induce unsustainable price movements, while often making it more difficult for companies and households to obtain credit due to not knowing how such an event will impact them personally or commercially. Examples include the 2008 Financial Crisis and Covid-19 Pandemic as examples of black swan events.

According to Nassim Nicholas Taleb, black swan events can be identified by their extreme rarity and severe consequences. Such occurrences cannot be explained using conventional statistics; by definition they stand out as outliers. Algorithmic trading can be susceptible to black swan events as its high-speed trades rely on split second decisions based on preprogrammed instructions. Programmed algorithms must be 100% reliable, provide complete data security, and avoid any fraudulent transactions. Mid to long-term investors such as pension funds, mutual funds and insurance companies appreciate algo trading for its ability to purchase stocks without creating significant price distortions with large volume investments.

4. Faulty Algorithms

Algo trading moves at lightning-fast speeds, making it hard to detect mistakes in an accurate and compliant algorithm. A mistakenly created algo can lead to massive losses for traders as well as disruption in markets and economies.

Algorithmic trading allows market makers to react instantly to orders in milliseconds or even nanoseconds, creating tight coupling through automated responsiveness that has alarmed many investors, particularly large institutional ones who may incur higher transaction costs due to proprietary algorithmic traders.

Trading algorithms tend to rely heavily on back testing techniques and curve fitting techniques, which may produce systems that look good on paper but fail when applied in live trading conditions. HFT algorithmic trading makes this issue worse by its fast pace allowing erroneous trades to quickly lead to significant losses – known as black swan events which can be hard to anticipate or prepare for.

5. Redundancy

Algorithmic trading has created an ecosystem in which failure or errors of individual trading systems can quickly escalate to widespread chaos – as in 2012 when Knight Capital experienced an algorithmic mishap resulting in a $460 million loss within 45 minutes.

Algorithmic trading requires being able to quickly respond to rapidly shifting market conditions and execute trades based on predefined rules. Unfortunately, this can create several risks related to over-optimization and curve fitting strategies; specifically when they’re optimized based solely on historical performance data and become unreliable under live trading conditions.

Large algorithmic trades pose another risk, as their influence on market prices can have a drastic effect, even leading to flash crashes. Furthermore, trading algorithms may be subject to various regulatory requirements and oversight that can be complex and time consuming for traders to comply with. There are ways of mitigating these risks; one method would be having multiple systems and data sources as well as having an incident response plan in place – both can help safeguard your profits in case something goes wrong with one system or data source.

You May Also Like

More From Author