Algorithmic Trading? Machine trading in the market? How are they actually affecting you as an ordinary investor?

You could have read or heard about the increasing trend of machine trading in the market. They follow certain algorithms and rules created by programmers in financial institutions and are faster in executing trades and investments.

What is algorithmic trading, really? According to Investopedia, they are programs that execute orders utilising automated and pre-programmed trading instructions to take into account variables such as price, timing, and volume. They are usually high-frequency in nature, meaning they execute a large amount of orders in a short amount of time.

You might not have seen them physically but they are there in the market.

Do you know how they are affecting you as an investor though?

#1: You Are Competing Against Machines

Rage Against the Machine? That’s right, you will trading and investing alongside cold hard machines in the market, whether you know it or not.

Many financial institutions have trended towards algorithmic trading that uses high-frequency technologies, to trade and invest in the market. Gone are the hyper-aggressive in-your-face traders working at their desks. They have now been replaced by savvy computer programmers who code numerous algorithms to profit off of price movements and trends.

Computers and machines will then spot these trends and opportunities in the market, and execute the algorithms automatically once they have been found. They are much faster, more efficient, and cover many more assets than normal human beings.

That is why you might see some irrationality in the market because more and more machines are trading the market. If they are programmed to trade certain conditions, prices will follow accordingly even though it has no basis to do so. Hence, as an average investor, investing according to fundamentals will get harder considering that machines are increasingly trading in the market. Garbage in, garbage out.

#2: Increase in Risk and Volatility

One of the defining characteristics of algorithmic trading is that it automates the task of looking for investment and trading opportunities according to a set of rules and code by the person behind the program. However, as it used mostly by big investment players in the market, the trades taken are large in size and will move prices significantly.

If you are holding an investment that is heavily traded by algorithms, you would potentially see large swings in prices. After all, different machines and algorithms with their own set of rules and codes will trade differently. Looking at the same trend in price, one algorithm will go long and another will go short. Who’s right? Who’s wrong? It doesn’t matter because you will face a risky and volatile situation anyway.

Facing volatile and risky prices, it certainly isn’t comforting to you as you will be wondering whether this is a fundamental shift in prices or just noise in the market caused by the various algorithms. Hence, the risk of investing increases as you also have to consider the role of algorithms in affecting prices.

If you are a trader, this is actually beneficial for you because you can trade more if prices are more volatile which gives you more opportunities to profit. However, that is only if you are on the right side of the trades.

#3: Makes You More Emotional

As highlighted in points #1 and #2, you are competing against machines and there are more risks and volatility. You get more uncertain about your investments and that in turn increases the stress of understanding which way your investments will go.

Emotions will run high when you see your investment go down by 10% in 5 minutes and there is nothing in the news suggest that it should go down that much. You get anxious and are worried that it will go down further, so you sell now to cut your losses. However, 5 minutes later, the price is back up towards its original price and you look at it feeling like you shouldn’t have done it.

That exacerbates your emotions and feelings when you are investing in the future. This actually has happened before on the bigger markets in the world. On 6 May 2010, the Dow Jones Industrial Average dropped by 1,000 points within a 10-minute span, and that lead other major indices around the world to experience the same thing. It rebounded shortly after. In the Securities Commission report, they cited highly automated trading programs as contributing and exacerbating the crash in prices.

#4: Makes Entry Point for Investments Harder

Algorithmic trading doesn’t just make your existing investments harder, but also trying to enter into an investment in the market is more challenging. For some of you who have done your research into the investment, the volatility caused by algorithmic trading could be problematic as it means that the price might not reflect the fundamental price.

As you have to bid for the price of the investment in the market, it means that you might not be able to obtain the price that you want to enter at. This actually makes it hard for beginner investors to get into the market and tilts the balance more towards bigger investors.

While you certainly can avoid investments that are heavily traded by algorithms, most of the good investments are traded by them. This reduces the incentive for ordinary investors to do their research if they realise that they can’t enter at the price they want.

#5: Reduce Profits of Other Investors

Algorithmic trading is mainly utilised by financial institutions where its speed and efficiency in executing trades and investments to profit is detrimental to ordinary investors like yourself. The amount of trades that they do is very large and swings prices in their favour.

Research by economists from the Commodity Futures Trading Commission showed that most of the gains from the market among high-frequency trading companies (algorithmic trading enables high-frequency trading) are concentrated in a few companies. They also found that high-frequency traders made an average profit of $3.49 per contract against ordinary investors.

With the advancement in computing power and the trend of financial institutions heading towards high-frequency algorithmic trading, it is probably going to be worse for you. More and more of the profits in the market will go to who has the best algorithm and computing power.

#6: Fundamental Research Might Be Less Relevant

This does not mean that algorithm trading is not based on fundamental research but rather it reduces the need to do in-depth research into investments. If you have an algorithm that you don’t understand but makes higher profits, you will use that algorithm and won’t bother conducting any research on it.

More and more financial institutions in the world are utilising deep learning to learn what are the most efficient ways to profit in the market. Bear in mind, the people who program deep learning only give the program specific instructions and they don’t actually know the process of how they do it or what the end solutions are going to be.

Fundamental research is one of the saving grace for ordinary investors as it allows you to reasonably compete against bigger investors by doing sound research. However, algorithmic trading is starting to be offered to ordinary investors like you where you don’t have to conduct much fundamental research anymore. For investors who have no access to algorithm trading, the odds are increasingly stacked against them.

#7: Pushes You to Not Do It Yourself and Towards Hands Off Investments

As mentioned in point #6, as more ordinary investors have access to algorithmic trading, they will exit the market and invest in them instead. This is also true for the robo-advisors out there (who may have algorithmic trading to rebalance portfolios) where more ordinary investors are actually starting to invest in. Passive investments such as exchange-traded funds that track the market are also becoming more popular.

This may not be all bad, as it means that you are actually spending less time worrying about your investments, and have a reasonably high likelihood of making money. After all, most of these investment products are managed by professional investors. If you don’t have the time to do extensive research, maybe it’s best to let them do it.

However, this also means that you are not giving yourself a chance to make higher profits for yourself and decide your own fate. This essentially means letting someone else decide how much profit you are making from your investments. You might want to consider doing it yourself to improve your investment and trading skills and as part of your financial journey.

Conclusion

Algorithmic trading is certainly changing the investing and trading landscape for you and many other ordinary investors in the market. There will be some challenges for you but when one door closes, another opens. Understand how it impacts you will prepare you for the eventuality of algorithms being more prevalent in the future.

 

Let us know in the comments below what you think of algorithmic trading!

You May Also Like