Algorithmic trading has numerous costs and benefits to it, but most opponents would agree that the main risk is that algorithms can misfire trades which were not intended as part of the logic. These “fat fingers” made by electronic systems can undoubtedly cause fallout risk greater than any human trader can, especially if you’re a large financial institution.

Take the story of Knight Capital. Back in August 1st, 2012, an erroneous section of logic in the code of one if its trading algorithms caused the massive firm to lose $440 million in just 30 minutes. Needless to say, this incident caused a lot of conversation regarding the safety and effectiveness of algorithms.

In the eyes of many, algos can be seen as a huge risk that is to be avoided at all costs. However, they rarely talk about the risk of great losses due to an individual’s lack of control while point and click trading. While comparing individual traders to Knight Capital is like comparing apples to oranges, we can all agree that the concept of risk management is the same. Opponents of algo trading stress that the individual is always in control of their system, and that ensures proper risk management. I beg to differ.

As a trader myself, I understand how disastrous your emotions can be to your profits and losses while trading manually. Humans are inherently flawed. We are stubborn creatures. When we’ve invested our time, energy, and capital into an idea, it is incredibly difficult to admit when we are wrong and accept failure. This applies even more so in trading. While trading, this can be the final straw that breaks the camel’s back. Not only are we taxed with the immense burden of identifying opportunities and capturing them, we need to make sure that we stick to our plan and disregard any emotions that try to sabotage it. We all know that sinking feeling in the pit of our stomachs when our trade goes against us, but that feeling is even worse when we panic and get out of a position prematurely before it moves in the way we had originally intended. Or even worse than that, when we marry ourselves to a position and accumulate greater losses because we’re too bias or stubborn to admit defeat.

Since we all know that feeling far too well, let’s relate it to trading with algorithms. These scenarios show us how important it is to prioritize risk management by mitigating and managing risk first, and then focusing on profits. With algos, this means ensuring that the proper safety checks, kill switches, and testing has been completed and in place before you ever put on a trade. For individual point and click traders, this means sticking to your plan and preventing emotions from taking control.

The catch, is that one way is easier than the other. Emotions are difficult to control, and it takes years of practice to eliminate them from your trading activity. Many traders fail because they can’t get a handle on them before their capital runs out. The huge benefit that is often overlooked with algorithmic trading, is that it allows you to completely eliminate all emotion from your strategy. By adopting algos, you’ve now allowed yourself to focus on risk prevention without your feelings getting in the way. You must prevent risk and have a plan for every possible scenario whether you trade manually or with algorithms, so I’d argue that adopting a system that removes all emotion from your strategy is one that gives you substantial control over your success. 

The mindset of a managing risk first, profits later is one that many traders lack, and it ensures that the ones that do have it stay successful for far greater periods of time.  While we’ll hear stories in the future of rogue programs that cause trading shop’s doors to close, very rarely do we hear of the untold hoards of aspiring traders that never get to a point of consistency and profitability due to their inability to control their appetite for risk.  I may be biased, but I believe that the means to achieve this exists. You just have to see the benefits that the opponents don’t want you to.

You may also like

Algorithms in the Overnight Sessions
Fixed-Income Trading Desks Making the Switch to Algos
The “Real” Traders

Professor Algo