Explained: What Is Algo Trading?

There are nearly 10 crore retail investors in India which shows a growing investment trend fuelled by technological advancements and regulatory measures. In recent years, algorithmic trading, commonly known as algo trading, has emerged as a game changer in the stock market.

In fact, citing increasing demand for algo trading by retail investors, the Security Exchange Boards of India on December 13 released its consultation paper proposing regulations for algorithmic (algo) trading by individual investors. 

But what exactly is algo trading and why is it generating so much buzz among the retail investors? Let’s understand.

What is Algo Trading?

Algo refers to ‘algorithm’ and algo trading is the use of computer programs and predefined instructions (algorithms) to execute trades in the stock market. These algorithms monitor livestock prices, analyse market trends, and automatically place buy or sell orders on the criteria set by the user.

To put it simply, it is a way to automate your trading decisions without the need for constant manual intervention.

Say, for example, you set an algorithm to buy a stock if it falls below Rs 100 and sell if it goes above Rs 120. Once the algorithm is set in place, it will execute these trades for you automatically, freeing you from the need to keep a close tab on market fluctuations and movements.

How Does It Work?

Algo Trading uses ‘Application Programming Interfaces’ (APIs) to build a link between the trader’s system and the stockbroker’s system. This builds an algorithmic connection via API, using which an investor can either.

• Use a pre-built trading algorithm provided by brokers or third-party vendors, or

• Develop their own custom algorithm tailored to specific strategies

• The algorithms run on the broker’s server to ensure that trades put on algo are executed instantly when pre-defined conditions are met.

• Such automation provides speed, accuracy, and the ability to react swiftly to desired market changes, something that manual trading typically lacks.

Are There Any Challenges/Risks Involved?

Though algo trading comes with many perks, it is not without risks, for instance, since algorithms are used in this method there is always a risk of unregulated or rogue algorithms which can disrupt market stability.

Moreover, since it is entirely based on computer technicalities there are always risks and challenges associated with system errors or bugs in the algorithm which can lead to unintended trades and significant losses.

Most importantly, many retail investors may lack the technical knowledge associated with fully understanding how the algorithms work which can throw them into any exploitative market trade activity.

Regulations To Keep Algo Trading In Check

Until recently, algo trading was not popular, even accessible to retail investors, and was majorly limited to institutional investors due to its complexity and cost.

However, technological advancements have improved its accessibility for retail investors through APIs. 

Sebi, therefore, has recognised this shift and is working to create a well-regulated and safe environment for retail algo traders.