Are You Planning To Start Algo Trading? Know These Risks

Last month, the Securities and Exchange Board of India (SEBI) proposed that brokers should only grant retail investors access to open Application Programming Interfaces (APIs) if they are certain whether clients intend to use them for algo trades or manual trades. If brokers cannot confirm the purpose, clients should not be granted API access. Thus Sebi aims to regulate algo trading practices to some extent. The investors should know the concerns of Sebi and the risks involved in algo trading also known as algorithmic trading.

Understanding Algo Trading; How It Is Done?

Algo trading means using computer programs to automatically execute trades in financial markets, i.e., buying and selling shares within milliseconds. These computer programs are built on complex mathematical formulas to trigger buy or sell orders without human intervention. Traders themselves set up the formulas, such as buying a certain amount of shares when they reach a specific price level (e.g. 50-week high) and adding additional parameters such as a certain trading volume is present and the X index is trading at a particular level.

To offer algo trading, brokers must secure prior approval from stock exchanges after informing their algo strategy. Retail traders access algo trading through such brokers' open APIs by paying them a fee. These APIs will stand as facilitators between the broker’s software and the client's platform.

Risks Involved In Algo Trading

Manipulation From Algo Developers: As mentioned above algo trading is done through mathematical formulas or algo codes. Only a few retail traders know how to write such codes and most of them, procure it through third-party algo developers. The main threat Sebi identified was these algo developers' promise of high returns to retail traders. Many developers reportedly sell basic strategies to retail traders, presenting them as sophisticated codes and charging hefty fees from retail traders.

Technical Glitches: Technical glitches pose another risk, which can lead to order execution delays. Software bugs can result in huge losses for investors. Market volatility can also impact algo trading, as algorithms may struggle to adapt to rapid market changes when there is high volatility. The platform may not be able to handle the vast amount of changing variables that lead to unwanted trades.

Incorrect Input Data: The success of the code depends on the parameters used to execute the trade. So the accuracy of input data is crucial for the success of algo trading. Incorrect data can result in unwanted trades getting executed that lead to financial losses for investors.