Algo Trading: Is it Really Emotionless?
Is algo trading emotionless? The answer depends on the person who’s asking the question, but generally speaking, the people who program automated trades don’t think it’s possible to remove emotions from trading altogether.
The issue lies in the fact that trading involves making decisions with money, and people are inherently emotional creatures when it comes to their own financial situations.
It doesn’t mean that you can’t learn to control your feelings while making investment decisions; it just means that you need to set clear goals and stick to them as much as possible.
The Human Connection
As a trader, you’re probably no stranger to emotional stress. If anything, trading is one of those careers that force you to confront your feelings every single day.
When you make a bad trade, for example, it can be hard not to feel frustrated or embarrassed about how much money you just lost.
Or maybe when you realize that other people are getting rich trading with methods that work and don’t rely on luck or hunches (like Elliot Wave Theory), it can be tempting to wonder why you were never born with their genius IQ.
That said, does all of your emotional baggage really need to show up at work every day? Can we ever detach ourselves from our emotions long enough to play an emotionless game of perfect strategy algo trading?
The Concept of Arbitrage
The idea of arbitrage is basic supply and demand. For example, let’s say you live in a large city, where there are multiple grocery stores. When you walk around your neighborhood, you see that there are two main stores that sell milk in your area.
These two stores typically carry different brands of milk—say store A carries Brand A and store B carries Brand B—and other than price, they appear to be exactly identical products. (In economics-speak we would call these homogeneous goods.)
Even though each brand is technically differentiated from one another by its own taste or packaging, consumers don’t care enough about those differences to pay more for them.
Dissecting Arbitrage - The Prequel to HFT
Algorithmic trading, or algo trading for short, can be a tricky strategy. The main drawback of algorithmic trading is that you are at the mercy of high-frequency traders who use market-making algorithms to trade against you.
If they have better software and faster connections, they can potentially get into trades before you do and then keep their profits. That is not a good way to start a business relationship with someone else who is also trying to make money off your mistakes!
So if you’re really looking for emotionless trading then make sure that your connection to other buyers/sellers of stock will be just as efficient as their connection so there’s no extra monetary gain from being on one side vs another in a trade.
Dissecting Arbitrage - The Sequel to HFT
In any quantitative trading strategy, there are fundamental components that are repeated from trade to trade. An interesting aspect of writing about quant trading is that most of these components can be repurposed for different asset classes and strategies.
The basic building blocks of arbitrage, such as volatility skew and tracking error, remain an integral part of most strategies.
This post will focus on how one might approach developing a systematic strategy in futures markets with an emphasis on volatility products such as VIX futures and VIX options.
The framework I'll use should be useful when considering many other strategies across various asset class
Reward Management in Arbitrage
To maximize profitability, arbitrageurs must adhere to strict reward management guidelines. One such guideline is called money management, which is a mathematical process that helps traders know when they need to take action or stop trading altogether.
Money management in arbitrage trades isn’t much different from managing rewards in other types of trading. It’s all about knowing what your account can handle before taking on a position based on how well you think it will perform.
The goal is to strike a balance between putting too much capital into any one trade, while also avoiding situations where you are not utilizing your available funds effectively enough.
Other Pros of Algorithmic Trading
Algorithmic trading platforms can let you trade with a small account, or from your laptop. This can make trading much more accessible for retail traders and novices.
Algorithmic trading eliminates human error. The software is tested for bugs, which means that your trades will have less of a chance to get messed up due to some silly typo or another mistake.
And you don’t have to be in front of your computer every second of every day watching markets, because these systems are automated—you just set them up, and then they do their thing while you go off and do something else.
You also won’t need to worry about getting scammed by unscrupulous brokers who may take advantage of you when you don’t know what you’re doing. Most importantly, algorithmic trading lets investors enjoy greater returns than those available through traditional methods.
With algorithms constantly analyzing market data and executing trades at lightning speed, even small investors can now profit from market movements like never before.
It doesn't matter if your capital is $100 or $100 million; algorithmic trading allows everyone to profit on major market shifts, not just high-volume institutions with deep pockets.
Drawbacks of Algorithmic Trading
Though algorithmic trading can appear to be a low-emotion form of trading, that’s not always true. Algorithms may execute with fast execution speeds and minimal error, but that doesn’t mean they are emotionless.
When an algorithm is trying to execute several orders at once in a thin order book, for example, there could be significant slippage.
Also, just because computers are executing trades does not mean humans aren’t deeply involved with these orders; placing algorithms in places such as dark pools requires humans to be doing due diligence on both sides of transactions.
There are even instances where algorithmic traders have been accused of front-running their own clients.
Finally, we should also note that many retail investors trade using algorithms or automated systems.
As you might imagine, emotions can run high when people feel like they don’t have control over their investments and don’t understand what is happening behind the scenes—and those emotions often cause investors to make rash decisions (e.g., selling at market bottoms).
The bottom line is that algo trading can eliminate some emotions from investing but certainly not all of them.
So what do you think about Algo trading? Do you think it really makes us emotionless traders or not? Please share your thoughts in the comments below!
Conclusion
Despite claims that algorithmic trading is emotionless, in my experience, human intuition is still present. Every trader needs to develop a different approach to trading with algos and maintain patience to achieve success.
The key is having a game plan—it doesn’t matter if you are using algos or not. But when emotions get involved, there’s nothing left but burning bridges.
Learning how to think calmly and know what your goals are is essential for trading success—regardless of the strategy or system used. Remember that computers don’t have feelings; as long as you remain neutral about losses, you will be one step closer to being profitable over time.
_11zon.jpg)
_11zon.jpg)
.png)
.jpg)
0 Comments