According to Investopedia, algorithmic trading are programmes that execute orders utilising automated and pre-programmed trading instructions to take into account variables such as price, timing, and volume.

They are usually high-frequency in nature which means that they execute a large amount of orders in a short amount of time.

That said, do you know how they affect you as an investor? Read on to know more.

Competing against machines

Many financial institutions have moved towards algorithmic trading that uses high-frequency technologies. These nifty computer programmers code numerous algorithms that make it easier to profit from price movements and trends.

These programmes identify trends and opportunities in the market, and execute the algorithms automatically once they have been found. They are faster, more efficient, and cover more assets than normal human traders. This is why you might see some irrationality in the market.

If they are programmed to trade in certain conditions, prices will follow accordingly even though it has no basis to do so. Hence, as an average investor, investing according to fundamentals will become more difficult.

Increase in risk and volatility

One of the defining characteristics of algorithmic trading is that it automates the task of looking for investments and trading opportunities according to a set of rules. However, as it is used mostly by big investment players in the market, the trades made are large in size and will move prices significantly.

As such, if you are holding an investment that is heavily traded by algorithms, you will potentially see large price swings.

These types of volatile and risky prices certainly make it difficult to isolate fundamental price changes between mere noise caused by the various algorithms. Hence, the risk of investing increases as you also have to consider the role of algorithms in affecting prices.

If you are a trader, this is actually beneficial for you because you can trade more if prices are more volatile, as it gives you more opportunities to profit. However, that is only if you are on the right side of the trades.

Makes you more emotional

Competing against machines will indirectly make you more uncertain about your investments and that in turn, increases the stress of understanding how your investments will perform.

For example, emotions will run high when you suddenly see your investment decrease by 10%, even though there was no news that suggested the change. The anxiety will then force you to cut your losses by selling, only to see the price bounce upwards again.

A similar situation actually happened before in May 2010 when the Dow Jones Industrial Average dropped by 1,000 points within a 10-minute span. This led to other major indices around the world to drop as well. However, it rebounded shortly after.

In the Securities Commission report, they cited highly automated trading programmes that contributed and exacerbated the crash in prices.

Difficult entry point for investments

If you have thoroughly studied your investment, the volatility caused by algorithmic trading could be problematic.

As you have to bid for the price of the investment in the market, it means that you might not be able to obtain the price you’re after. This actually makes it difficult for beginner investors.

While you certainly can avoid investments that are heavily traded by algorithms, do note that most good investments are traded by them. This reduces the incentive for ordinary investors to do their research, especially once they realise that they can’t make an entry at their preferred price.

Reduce profits of other investors

Research conducted by the Commodity Futures Trading Commission showed that most of the gains from the market among high-frequency trading companies (algorithmic trading enables high-frequency trading) are concentrated in a few companies.

They also found that high-frequency traders made an average profit of US$3.49 per contract against ordinary investors.

With the advancement in computing power and the trend of financial institutions heading towards high-frequency algorithmic trading, it is probably going get worse for ordinary investors.

Fundamental research becomes less reliable

Algorithm trading reduces the need for in-depth research into investments. If you have an algorithm that you don’t understand but makes higher profits, you will still use that algorithm and won’t bother conducting any research on it.

However, do bear in mind that the people who program deep machine learning only give the programme specific instructions wile failing to understand the entire spectrum of investing.

Fundamental research is one of the saving graces for ordinary investors, as it allows you to reasonably compete against bigger investors by doing sound research.

Adapting to hands-off investments

As more ordinary investors gain access to algorithmic trading, they will eventually exit the market and invest in programmes instead. Passive investments such as exchange-traded funds that track the market are also becoming more popular.

This might not be a bad idea at all, as it means that you are actually spending less time worrying about your investments. After all, most of these investment products are managed by professional investors. If you don’t have the time to do extensive research, maybe it’s best to let them do it.

However, this also means that you are not giving yourself a chance to make higher profits for yourself by taking charge of your own fate. You might still want to consider doing it yourself to improve your investment and trading skills as part of your overall financial journey.

This article first appeared in MyPF. Follow MyPF to simplify and grow your personal finances on Facebook and Instagram.