Responsible Algo Trading: Use tech without over-leveraging investment

One of the revolutions that has hit capital markets and the world of trading is algorithmic trading, also known as automated trading or algo trading. Giving traders and investors a faster, disciplined and easier way to trade; algo trading uses a computer program with a pre-defined set of rules to execute trades automatically. Its speed, accuracy and precision have given it an edge over manual trading as it's an efficient, faster and scalable way of trading. 

However, most investors and traders tend to forget that algorithms alone don’t contribute to making any money; it’s the right blend of trading logic appropriate to the prevalent market conditions which helps achieve the desired results, similar to manual trading. 

What investors need to understand here is that, like manual trading, algo trading also has some inherent risks that need to be mitigated to achieve the desired results. Let’s understand how to avoid over-leveraging and responsibly use algo trading to achieve one’s goals. 

Perils of over-leveraging in algo trading
Over-leveraging is an investor’s nightmare if things don’t pan out like they had imagined them to be. When an investor borrows too much money to increase his investment in the market, in relation to the ability to repay, he over-leverages his investment and it can be catastrophic. 

There are many risks associated with over-leveraging that an investor needs to pay heed to while algo trading. Firstly, no one controls the market, and it may move in your favour or against you. If the market moves against your investment, the brokers may issue margin calls, demanding additional funds for the maintenance of your position in the market. In such a case, you may be unable to meet the demand, which may cause liquidation at a loss. 

Secondly, over-leveraging exposes traders to extreme market conditions like spikes. Sudden and extreme price movements can trigger sudden stop losses and related trigger effects, thereby causing an algo performance decline. 

Finally, emotional decision-making, even in algo trading, by over-leveraged investors can prove to be catastrophic. 

With so many risks associated with over-leveraging, algo traders and investors need to focus on mitigating these beforehand to achieve their desired results. 

Mitigating risks for smooth algo trading
The risks associated with over-leveraging can be countered with certain measures. While being responsible and disciplined applies to everyone, for traders and investors, certain steps can help avoid these risks. 

One of the measures that can be helpful here is hedging. It involves taking an opposite position in another related asset to offset any potential loss associated with an investment. Another way is to have risk management measures in place for every position. Never, ever leave any position naked. Some form of protection is needed for every investment to mitigate the risks. An investor must implement measures like stop loss and position sizing to safeguard against risks. 

Another resort is to conduct stress testing before initiating investment. Assume the worst-case scenario in adverse market conditions to see how your investment strategy will react to those. This will help you to understand whether your algo trading strategy is robust enough to be resilient under adverse market conditions and safeguard your investment. 

Be prepared to square off positions sensibly in case of technological disruptions while algo trading. If there’s an issue with server connectivity or failure of any algo system, not squaring off position might negatively impact your investment. Also, it would be great to have an emergency fund before going in for over-leveraging in the market. This emergency fund may come in handy in adverse market conditions. 

Lastly, always have a contingency plan. Every investor must know what to do incase of any unexpected market disruptions that may prove detrimental. Strictly sticking to the contingency plan in adverse market situations can help avoid catastrophic losses. 

While algo trading and its revolutionary technology have made things easier for traders and investors, there are inherent risks that, if not mitigated, can prove catastrophic for investors. 

Luckily, by carefully understanding the risks associated with over-leveraging an investment and putting measures in place to mitigate these, investors can take advantage of robust technology without any harmful impact on their financial well-being. One must keep in mind that a balanced approach is what helps when it comes to algo trading, and that is what one must focus on. 

-- Kunal Nandwani, Co-Founder, uTrade Solutions.