Advantages of Algo Trading
Now that we have a basic understanding of what Algo Trading is, let us discuss some advantages and disadvantages.
Firstly, let us start with the advantages.
The popularity that Algo-Trading has achieved in a little while is a testament to its profitability. There are also several benefits associated with it such as:
- Speed - High-Frequency Trading or HFT is an extension of Algo-Trading. It is used to place a large number of buy/sell orders across exchanges in a jiffy primarily to make profits from asset mispricings or bid/ask spreads. A study conducted on HFT in India highlighted that the average profit per trade stood at around 2 basis points or 0.02%. Traders employing HFT conduct trades at a lightning speed of 64 millionths of a second! Yes, you read that right!
- Accuracy- Algo Trading can considerably reduce slippages by executing orders on pre-determined specifications. Automated Trading also eliminates the risk of fat-finger errors. Order execution will be precise in absence of human intervention.
- Cost-efficient- Algo Trading enables the execution of a large number of orders in a short span. With increased volumes, transaction costs are reduced as many trades may be processed at once. For instance, option trades are generally charged at ₹20 per order regardless of the order size. A person buying/selling 100 options contracts pays the same brokerage charges as someone who buys/sells a single lot. It is simple economies of scale on function.
- Human emotions have no role to play- What better than this for those traders who find it difficult to stick to their rulebook & frequently indulge in sins such as overtrading, over-leveraging, no stop losses, poor risk management, improper position sizing, etc.
- Backtesting- The probability of success for an algorithm can be verified by backtesting it on historical data. Based on the results, strategies can be fine-tuned to perfection & made viable to use.
- Automation of the asset allocation process- Usually institutions such as Mutual Funds houses, Insurance companies, Hedge Fund managers, etc stick to a particular asset allocation say 60:40 debt to equity. Similarly, an individual investor may not want to allocate more than 20% of his capital to a single sector. An automated trading algorithm helps to maintain the optimum asset allocation by frequently rebalancing the portfolio.
- No need for constant monitoring- A trader does not need to be glued to the screen all the time if he has an algorithm in place. He can devote time to other activities and simply let money work for him.
- Enhanced liquidity- Algo Trading has greatly helped in improving the market depth as well as the overall liquidity in the market. This has led to increased participation since investors generally prefer liquid markets as they are less prone to manipulation.
- Diversification- An investor can scan opportunities across markets, assets & instruments simultaneously. This diversification would have been challenging to implement otherwise if not for automation & algorithms.