Pros and Cons of Automated Trading Systems
Are you ready to trust your trading strategy to bots? Read about the advantages and disadvantages of algorithmic (algo) trading.
Updated May 17, 2021 • 2 min read
Automated, or algorithmic (algo), systems across all asset classes execute pre-set orders that can exclude the influence of human emotion or market swings. This is one advantage of algo trading, as emotional trading can result in overtrading, which in turn can trigger losses. Another benefit of algo trading is that a computer-managed system lets you trade multiple accounts and strategies simultaneously. Algo trading can help to reduce the incidence of mistakes made by humans when placing trades and can identify profit and loss (P&L) opportunities much faster than a human trader. Algorithmic trading is not for novice traders. It relies on expensive, complex software and takes place primarily at large investment banks, hedge funds, proprietary trading firms, and regulated cryptocurrency exchanges.
Trading is about making money — not losing it — but unfortunately, many do, in fact, lose. People often correlate losses with emotional trading or becoming too personally invested in the outcome of a trade. Over-involvement can lead to over-thinking and then to over-trading, which in turn may lead to loss. In the discipline of trading, it can help to stick with a consistent strategy. Automated, or algorithmic (algo), systems across all asset classes execute pre-set orders that can exclude the influence of human emotion or market swings. As a burgeoning asset class with a fast-growing infrastructure, cryptocurrency exchanges have also begun to give customers the ability to execute automated trading strategies through the use of trading bots.
Still, automated trading platforms are not without drawbacks. For starters, computers depend on a strong internet connection and a reliable source of electricity to function. Moreover, some trading strategies are so complex that computers cannot execute them efficiently, and may require constant monitoring and human intervention anyway. So whether you’re an individual investor or a professional trader, you should carefully assess whether or not automated trading systems would enhance or detract from your trading style.
Advantages of Automated Trading Systems
Eliminates Trading Based on External Factors: Algorithmic software generally calls for each trade to be programmed, which means traders can avoid reactionary or ill-considered buying and selling based on negative economic or company news, or from fear of missing out (FOMO) on a lucrative asset. Algo trading can also prevent quick-finger transaction mistakes — like accidentally omitting a zero on a sell order price.
Provides Opportunities for Backtesting: In trading, backtesting refers to when an investor looks to history for clues about how to invest in the future. With this strategy, you can use historical market data to test whether a certain trading plan will work based on past results. You can then automate that plan rather than guessing and potentially losing funds.
Automation Keeps You On Plan: Many traders start out with a trading plan, only to forget about it over time. A common aphorism in the investment community is “plan the trade, then trade the plan.” The latter is much easier if you automate your trades to consistently execute your trading plan in pursuit of profitable results during a particular period.
Helps You to Stay Diversified: Trading is all about maximizing profits while minimizing risks, and algo trading solutions can help traders achieve this goal at a much faster and error-free pace than trading manually or with analog tools. Computer-managed systems allow you to trade multiple accounts and strategies simultaneously, and identify profit and loss opportunities through ultra-fast market scans.
Disadvantages of Automated Trading Platforms
Watch Your WiFi and Power Source: Algo trading systems are electronic, meaning they depend on a reliable power source — and more crucially, a strong WiFi connection. If your automated trading software functions on your own computer instead of on a broker’s software, a failed internet connection can trigger a big loss if orders are not fulfilled on time.
Over-Optimization: In addition to backtesting, some trading platforms contain an optimization tool. This feature allows you to enter a range for the specified input and tells the computer to figure out which input would have worked the best for your strategy. Some systems have multi-factor optimization capabilities that let you input many variables — combinations of scenarios — to see their effects on the end result. Unfortunately, though an enticing exercise, optimizing a backtest in this way often leads to a system that performs poorly in reality. When this happens, your strategy is said to be “over-optimized,” meaning it’s too complex for the system to apply it in the real world; it looks good on paper only. For this reason, it’s a good idea to start your automated trading practice with small, simple orders and build expertise over time.
Algo Trading Software Is Complicated and Expensive: In general, algorithmic trading happens primarily at very large trading firms, such as investment banks, hedge funds, and proprietary trading firms. Because of their resources, these firms generally build their own proprietary trading software. In terms of individuals, some experienced proprietary and quantitative traders also use algo trading software. Quantitative traders usually are savvy enough to build their own software. But, proprietary traders who may not be so tech-savvy must buy the software, either from their brokers if they offer it, or from a third-party vendor. The algo-trading software that’s available to anyone off the shelf is generally inferior in one or more ways — it can contain loopholes, missing documentation, and so on. If you’re thinking of purchasing off-the-shelf algo-trading software, you likely should bring an expert consultant along with you. Further, for the average person, algo trading software is prohibitively expensive.
Scammers: Scammers are everywhere, and automated trading systems are no exception. If a system promises something that’s “free” or “too good to be true,” you should be very skeptical. Research the provider of an automated trading system thoroughly before paying any money for its services, and be sure to look at the fine print. Compare and contrast the system with competitive offerings and read customer reviews across a range of reputable websites.
Should You Automate at All?
If you’re trying to trade from your home computer, then an exchange’s server-based automated trading system can help you to avoid catastrophe from a failed personal internet connection. But if you’re wondering whether you should go the route of algorithmic trading at all, then consider it carefully because setting up a viable algo strategy can take a lot of time, money, and technological sophistication. If you’re a professional trader, then algo trading is worth a try to see if it’s a good match for your trading style and temperament.
If you’re a disciplined individual trader with extra time and money to spare and a high tolerance for risk, then you might wish to try your hand at algo trading. But before you launch full scale into it, think about starting with a very basic custom or “wizard” strategy until you’re more familiar with algo trading. A wizard strategy is essentially a template that you can customize based on your own parameters and trading goals. Moreover, some traders believe that mixing automated and manual strategies produces better results. So that also could be a technique to try before you commit fully to algo trading.
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