Algorithmic trading is the use of computer algorithms in trading large groups of stocks or other financial assets while also minimizing the effects of such trades on the markets.
With algorithmic trading, you place trades based on a set of criteria. Then, you divide the trade into smaller lots so the price of the stock isn’t affected significantly.
Proponents of algorithmic trading say it ensures the best execution of trades because it decreases the human element.
What about high-frequency algorithmic trading?
High-frequency algorithmic trading, on the other hand, is the next-level method of algorithmic trading. This strategy involves placing thousands of orders at a super rapid speed, with the goal of making tiny profits on each trade.
Algo trading and high-frequency trading have already become an extremely important part of the financial markets because of several factors like the role of technology, complexity of instruments, and others.
Amplified Systemic Risk
But high-frequency algorithmic trading isn’t completely without risks.
According to the 2011 report by the International Organization of Securities Commission (IOSCO) Technical Committee, algorithm running across markets can transmit shocks quickly from one market to the next due to the high level of links between markets.
In other words, this type of trading amplifies the systemic risk of the market.
How does it amplify systemic risk?
There are many ways algorithmic trading amplifies systemic risk.
Since there’s a heavy volume of algorithmic high-frequency trading in the markets nowadays, trying to outperform the competition is a priority for most algorithms.
And they can react instantaneously to different market conditions. When markets are volatile, algorithms could greatly widen bid-ask spreads. Sometimes, they stop trading altogether. Such a scenario diminishes liquidity and worsens volatility.
Because of the increasing degree of integration between markets and asset classes, a downturn in a major market or asset often ripple across other markets and asset classes like in a chain reaction.
High Level of Uncertainty
Algorithmic high-frequency trading is a huge contributor of market volatility. And high volatility can spur investor uncertainty in the near term and impact consumer confidence over the long term.
When a market suddenly collapses, investors wonder about the reasons for such a dramatic move.
And while the markets suffer from a news vacuum, large traders using algorithmic trading will often cut their positions to scale back risks.
And such a move puts downward pressure on the markets, paving the way for a negative feedback loop.
There exist other forms of high-frequency algorithmic trading risks.
The super-fast speeds of most algorithmic high-frequency trading means that one faulty algorithm can record millions in losses in a matter of seconds.
High Investor Losses
Investors might suffer great losses because of the high volatility permanently saddled on high-frequency algorithmic trading.
No Confidence in Market Integrity
Investors believe in the financial markets’ integrity, so they risk their hard-earned money as they invest in assets.
However, unusual market volatility and uncertainty and shake this confidence up and might result to many investors giving up on the market because of loss of confidence.
The key to success is awareness. That’s why you need to go and check Finance Brokerage educational websites available. And you can choose the one that suits you the best in the Online Trading Courses offered.