Please ensure Javascript is enabled for purposes of website accessibility

What Is Algorithmic Trading?

By Motley Fool Staff – Apr 27, 2017 at 10:08AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

In the battle of man versus machine, sometimes computers win out. Here's how algorithmic trading works, and why this trend has grown so popular among investors.

Many of us are coming to rely more and more on computers and technology than ever before, and investors are no exception. Thanks to algorithmic trading, a growing number of investors are taking advantage of what they consider to be optimal market conditions to come out considerably richer.

Also known as algo trading, algorithmic trading is a method of stock trading that uses intricate mathematical models and formulas to initiate high-speed, automated financial transactions. The goal of algorithmic trading is to help investors execute on specific financial strategies as quickly as possible to bring in higher profits. While there are a number of key benefits to algorithmic trading, there are also some risks to consider.

Using technology to trade

IMAGE SOURCE: GETTY IMAGES.

How algorithmic trading works

An algorithm is a process or set of defined rules designed to carry out a certain process. Algorithmic trading uses computer programs to trade at high speeds and volume based on a number of preset criteria, such as stock prices and specific market conditions.

As an example, a trader might use algorithmic trading to execute orders rapidly when a certain stock reaches or falls below a specific price. The algorithm might dictate how many shares to buy or sell based on such conditions. Once a program is put in place, that trader can then sit back and relax, knowing that trades will automatically take place once those preset conditions are met.

Benefits of algorithmic trading

One major advantage of algorithmic trading is that it automates the trading process, ensuring that orders are executed at what are deemed to be optimal buying or selling conditions. Because orders are placed instantly, investors can rest assured that they won't miss out on key opportunities. Manual orders, by contrast, can't come close to mimicking the speed of algorithmic trading. Additionally, because everything is done automatically by computer, human error is virtually taken out of the equation (assuming, of course, that the algorithm is developed correctly).

Furthermore, algorithmic trading often limits or reduces transaction costs, thus allowing investors to retain even more of their profits. Finally, algorithmic trading eliminates the dangers of acting on emotion instead of logic, which investors are known to do.

Drawbacks of algorithmic trading

One major disadvantage of algorithmic trading is that one simple mistake can rapidly escalate in a major way. It's one thing for a trader to make a bad call and lose money on a single transaction, but when you have a faulty algorithm, the results can be downright catastrophic. That's because a single algorithm can trigger hundreds of transactions in a matter of minutes, and if something goes wrong, millions of dollars can be lost in that same time frame.

In fact, there have been multiple incidents of "flash crashes" on global markets resulting from problems with algorithmic trading. For example, algorithmic trading was blamed for the "Flash Crash" of 2010, which led U.S. stock indexes to collapse (though they rebounded within an hour), as well as an October 2016 crash that saw the British pound plunge toward its 31-year-low in a single night.

Algorithmic trading has also been linked to significant market volatility. While quality control measures can help prevent losses owing to poorly defined or coded algorithms, investors should be aware of the dangers of giving up control and letting computers do all of the work.

This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at [email protected] Thanks -- and Fool on!

The Motley Fool has a disclosure policy.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

HOW THE MOTLEY FOOL CAN HELP YOU

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning analyst team.

Stock Advisor Returns
329%
 
S&P 500 Returns
106%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 09/25/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.