Disadvantages of Algo-Trading
Algo-trading, also known as, a black-box trading sound fancy, but is something that people with a weak heart should avoid. Algo-trading in simple terms is the use of automated, pre-coded strategies and computer-programs to execute a trade.
Though algo-trading comes with various benefits, there are multiple reasons that hold majority of traders to switch to it. Before you step into the world of automated trades, here are few disadvantages of algo-trading you should be aware of.
Disadvantages of Algo-Trading
Lack of Programming Knowledge
Formulating strategies and algorithms for algo trading requires coding knowledge of software like C+, C++, Java, etc. Most of the financial professionals and general traders lack the coding and programming knowledge. The better idea is to get the code written from the experts. Hiring a professional coder is also essential as the codes need to be modified with respect to the current market conditions. Thus, having a programming foundation is essential when opting for algo trading.
Higher Dependency on Technology
There have been instances when the markets have crashed down. For instance, Nifty crashed around 900 points in 2018 and recovered fully at the end of the day. During such instances, algo-trading triggers a stop-loss which further adds to the existing selling pressure in the market.
Regulatory Restrictions
When it comes to algo-trading, different countries have different regulatory restrictions. SEBi (Securities and Exchange Board of India) too has come up with a strict line of measures to control market volatility and reduce systematic risk associated with algo-trading.
Reduced Lifespan
Market are inherently volatile. Hence, it becomes necessary to accommodate changing market landscape to your algo strategies. The formulation of algorithms and strategies is a regular and a continuous process. This requires regular monitoring, improvising, and innovating the strategies from time to time according to market conditions. Thus, there are chances that a strategy will be short lived and will be changed as soon as the market scenario changes.
Resources Required
If a trader is opting for algo-trading he/she needs to make arrangement for high end resources to carry out trades. Along with the high end resources, low latency infrastructure too is required to successfully carry out algo-trading. This increases the co-location costs that are associated with algo and high frequency trading. The lack of expertise among the traders and troubleshooting makes algo-trading altogether more expensive making it unviable for medium and small broking firms.
Over Optimization Risk
Algo-trading strategies once written are first applied to paper trading before being applied to live trading sessions. Chances are that despite checking and back-testing these strategies via paper trading they may fail to perform during live market sessions. The back-tested data represents a specific market period or condition which might be similar to the current market scenario. However, there is always a risk that the program might not fit in the live trading session thus leading to a risk of over-optimization.
All Strategies Cannot Be Automated
Though you can easily automate your strategies there are some excellent strategies that cannot be automated. This is because all strategies cannot be converted to an algorithm. Hence, use of such strategies becomes impossible in algo-trading. By this the possibilities of making more money are reduced despite having excellent strategies as they cannot be automated.
Thus, though algo-trading comes with a range of advantages that up your trading experience, it has its own disadvantages too. One needs to be cautious and aware of the risk associated with algo trading before opting for the same.
