Risk Management in Algo Trading

Algorithmic trading or Algo-based trading has not only enhanced the speed and frequency of trading but also provided a dynamic platform for traders to choose the right trading strategy as per the market conditions. It is an automated trading solution that can perform millions of multiple transactions at high frequency and can make higher profits.

However, every aspect has its own pros and cons, so trading with algorithm-based software also has some disadvantages. There are certain risks that you need to understand associated with algo trading. Managing the risk is also very much important to make your algorithmic-based trading journey profitable with less risk of losses.

Topics Covered :

• What are the Types of Risk in the Stock Market?
• What is risk Management in Trading?
• What are the Risks of Algorithmic Trading?
• Algo Trading Risk Management
• Final Words

What are the Types of Risk in the Stock Market?

There are various factors that affect the stock market and the underlying securities trading on the exchanges. Factors like volatility in the market, news or events, company-specific corporate actions and technical factors all affect the price of an underlying security.

There are different types of risks in trading including market risk, liquidity risk, regulatory risk, credit risk and technical risks. All these risks can arise any time and can affect the trade decisions and if ignored or not taken seriously, cause loss in trades. Hence, managing such risks is very important to minimize the losses and maximize the returns.

What is risk Management in Trading?

Risk management refers to minimizing the impact of risks by keeping traders well-informed about such events timely and choosing the right trading strategies so that they can earn maximum profits and minimize losses. Risk management helps to understand the market behaviour, choose the right underlying security as per the market conditions and trade efficiently.

In trading, risk management is all about removing all the technological barriers, analysing all the factors affecting the market and then making a well-informed decision for trading. During trading if any issue arises, you must have a quick solution to deal with such risks. A human-backed trading system can be controlled by the people involved in the operations.

However, risks that are associated with market and external factors need to be addressed technically. And automated software system can also face similar risks that are practically possible while trading in various segments of the market.

Recommended Read: Algo Trading Advantages

What are the Risks of Algorithmic Trading?

In algo trading, there are a few different types of risks like operation risk, technological breakdowns, scalability and lack of resources to run the algorithmic software efficiently. Managing this risk is crucial but also very much important to make the best use of such Algo-based software systems. Let us know what algorithmic trading risks are.

Market-Related Risk:

The unusual movement in the market due to high volatility or unexpected events can disturb the performance of the algo software. Although, most of the market-related risk can be adjusted by such software but still some unexpected situations become risky for the traders.

Technological Risk:

Algo trading is a fully system-based trading mechanism that works itself based on a set of certain rules and programming. Hence, while performing trading and operations, unexpected technical malfunctions can affect the entire trading activities.     

Operational Risk:

This is like managing and operating the entire trading activities that involve algo software management, lack of structured policies and various other activities organized while performing trading-related actions. These all are also risk for the algo trading system.

Risk of Resources:

To organise or perform algo based trading solution, you need highly efficient infrastructure and resources. If you fail to do so or don’t have that required resources, your algo trading cannot be implemented and there could be a risk of malfunctions.

Risk of Scalability:

Human resources can be enhanced by deploying more people at the time if we need to handle more tasks. However, a system having limited capacity would be unable to scale if there is extraordinary demand in unexpected market conditions. Hence lack of scalability is another risk for the algo-based trading systems.

Algo Trading Risk Management

The question that arises here is how to manage these risks that affects the performance of algo-based trading system. In fact, a robust risk management technique is required to handle these risks that are associated with high speed, complexities and set of multiple hardware as well as software technologies. Find below the best risk management practices for algo trading.

Well-defined Investment Goals

Define your investment goals and trading-related objectives, how much money you are ready to invest for what time period. How much return do you expect and by what time do you need to liquidate all your investments made in such assets?

You also need to define the level of risk you can absorb in uncertain market conditions. All this will ensure your trading strategy is aligned with your investment goals reducing the overall risk levels in trading with such high-frequency trading mechanisms.

Stop-Loss & Profit Booking

Trading without stop-loss in the stock market is like playing a risky game without protection. Stop-loss in trading helps to minimize the losses if the market is not moving as per your expectations. In algo trading, you can also choose to set the stop loss at a fixed price or use trailing stop loss, as per the volatility of the underlying security or your risk and reward ratio.

Dynamic Position Sizing

The size of your trade position should be also flexible to adjust as per the prevailing market conditions. You can allocate the size of funds or your trading capital to other trade positions from high-risk securities to low-risk securities reducing the exposure to high risks. This will also limit the potential impact of losses on your entire investment.

Diversification of Portfolio

Putting all your eggs in a single basket has the risk of losing all of them if broken or damaged forcefully. This rule also applies in the stock market trading. Yes, if you invest all your money in a single asset, it will be exposed to various risks. Hence, diversify your portfolio by investing in multiple types of securities to minimize exposure to individual risks.

Monitoring and Evaluation

Algorithm-based software systems are an automated trading mechanism that works when the trading strategy is as per the market conditions. But still, you need to monitor its performance and results, if any unexpected risk arises you can deal with it timely.

Also, evaluate the performance of your portfolio and adjust if not work as per your expectations. Regular monitoring and evaluation will help you reduce various risks associated with trading mechanism and with underlying security to maximize the returns.

Hedging-backed Trading Strategies

Hedging is one the very effective techniques or you can say the best trading strategy in the risk management of algo trading. Avoid entering into the single trade positions, instead use the combination of cash market, future and options strategies to minimize the impact of uncertain market conditions.

Though, hedging based trading practices can increase your cost of investment and reduce the rate of returns, but can give you consistent returns with better chances of giving the returns in various market conditions at the minimum level of risks.

Final Words

Proper risk management in algo trading not only reduces the risk of investment but also improves the overall returns when evaluated with a mix of multiple trades. To deal with such risks, you need to adopt robust risk management techniques and best practices that are adopted by most traders globally while trading with such high-frequency trading mechanisms.

One of the most important things to manage risk in this automated trading system is to choose the right trading platform that operates with strong risk management principles. Backtesting and stress testing of such trading platforms will help to evaluate the performance of trading strategies stored in such algometric software. Religare is one the leading broking houses in India and offers the best algo-trading solution with robust algorithmic software at the lowest pricing.

Recommended Read: Algo Trading Vs Manual Trading