Three Disadvantages of Algo Trading

Capital Markets CIO Outlook | Wednesday, August 25, 2021

Algorithmic trading, also known as black-box trading, automatic trading, or algo trading, has grown in importance for brokers and traders since its inception in the 1970s as the computerization of order flow.

Fremont, CA: Algorithmic trading platforms, in theory, can generate returns at a rate and frequency that human traders cannot match. High-frequency trading (HFT) has been the most popular application of algorithmic trading platforms, in which a computer analyses various markets and executes orders based on predefined criteria.

While there are tangible benefits to algorithmic trading, such as the development of precise entry, exit, and money management rules and the elimination of emotion from the trading process, there are also drawbacks to using these platforms.

Here are three disadvantages of algorithmic trading:

Over-Optimization

Although algorithmic trading platforms can be backtested to assess their capabilities before going live, there is a risk that a software would be over-trained to match specific patterns. Due to the differences between the modern market and the data sets, it was trained on, a platform might be trained on historical data and produce outstanding results in responding to patterns from that data, but when applied to a modern market, it may fail to produce the same results. Traders may be lured into developing what they believe is a foolproof trading strategy that generates returns under very complex market conditions that might never occur again, only to feel as if their scheme has failed when those returns are not repeated in the real world.

Maintenance Issues

During the execution of trades, an algorithmic trading platform requires operational hardware. To ensure that the system runs smoothly, dedicated machines, servers, and connections are needed. Although automated trading systems and algorithms which appear to be “set it and forget it” platforms that a trader can set up and forget about, the truth is that they are more complicated. Some platforms don’t rely on internet connections or data servers entirely, instead storing pending trade orders on the client’s device. The exchange will not take place if the link is lost.

Erratic power outages would also prevent the system from executing trades. Platforms can also be harmed by Exchange-based server crashes and glitches.

Monitoring

Automated trading systems must be monitored due to the possibility of bugs, crashes, and power outages. Traders can set up monitoring and surveillance teams that are qualified to use both visual and auditory warnings, according to Nasdaq. It also proposes forming a committee made up of members from the trading, customer coverage, compliance, risk, and credit departments to regularly review practice and control levels. Smaller trading companies looking to automate without risk could not be able to execute such a strategy.

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