Retail Investors Need To Be Cautious About Algo Trading, Regulators Have To Be Wary About Black Swan Events

Algo trading has become the hot topic in the last few years in the space of stock market. Retail Investors also have not gotten uninfluenced by the realm of algo trading. Retailers are becoming aware about the benefits that algorithms provide in the world of trading and are ready to take dive in the ocean of this automatic trading.

As we know, algo trading is an automated way of trading, which uses computer programs to make trades based on a set of rules. It's like a human trader who sets up stop loss limits and profit targets. The difference is that an algo trade has no emotions or feelings. They just follow the rules that have been written in by their programmer.

In India, there are many sorts of algo trading platforms available for traders to use. Some allow you to specify your own parameters for executing trades while others rely on computer models designed by experts in finance or economics fields. Algo trading in India has revolutionised the way people trade.

There are many advantages of opting algorithmic trading strategies. The main advantage is that it allows traders to execute trades at predetermined times and prices, thereby reducing the risk of error that occurs when manually placing orders on an exchange. This way it helps eliminating emotion from decision making, which can lead to bad decisions being made when it comes to choosing whether to enter a position at any given time or exit.

Worry Of The Retail Investor

Today, algorithmic trading in India is used by a lot of retail traders because they are easy to use and can be customised based on an individual's trading style. But the main hindrance that Indian retail traders are facing is that Institutional investors have more liberty than them when it comes to algo trading. Retailers are usually relying on brokers for using these pre-built algorithmic models for opting algo trading. All the trading orders are conducted only by the brokers servers.

Furthermore, with this limitation some associated risks spontaneously arise. Other than the technical glitch, the main threat that scares the retailers most is any kind of manipulation done by the brokers put them in the worst situation. Any loophole in the strategy coded and designed by the brokers can make them suffer huge losses. Moreover, most of the algo trading providers available in the market are unregulated, that put the retailers in the dark situation, where no such facility of redressal forum is provided to them.

Thus, by considering all these threats to the retailers, prevailing in the Algo Trading world, SEBI is purposing some rules and guidelines to regulate the framework of Algo Trading in India. The regulatory body is mainly worried about two major threats that can put retailers in trouble. First is false promises of huge yields or profits made by brokers to the retailers while opting for Automatic Trading. Second is any kind of scheming by the brokers.

To mitigate these threats SEBI is formulating a framework, according to which the brokers should offer open application programming interface (API) to all their algo clients all the orders conducted via API will be considered as Algo orders. Additionally, APIs that are used for operating Algo Trades should have unique Identification provided by the exchanges to enhance the transparency. Also, it suggests that brokers should use high tech tools of algo to avoid any type of technical glitch. Through these crucial initiatives, SEBI is trying to protect the retail traders and increase confidence in them towards the algo trading.

The Black Swan Threat

Moreover, Black Swan Events should also be kept in mind. Such events are basically unseen events or sudden occurrences which have various negative outcomes which further needs to be dealt with. These events are completely unpredictable, cannot be forecasted though traditional forecasting methods. They are very rare in nature and result in creating a devastating effect.  Most recent and highly impactful Black Swan event would be the lockdown due to Covid-19 virus.

In relation to the Stock Market Black Swan events refer to unexpected crisis which could be due to any big news or policy changes which leads to sharp and abrupt decline in the stock prices or the entire market impacting the index, volatility comes in to play investments becomes extremely risky which can result in huge losses for individuals. Nations are well connected globally. Henceforth, the Russia-Ukraine war had its impacts globally and had its repercussions on the entire, where we saw the oil prices rising by huge margins thus impacting various sectors in India Like the Auto, Chemicals, and the paint Industry. 

Regulators must be extremely cautious in dealing with such unforeseen events. First and foremost, creating resilience is the priority which means to always have a backup plan or Plan B to tackle with the aftermath of such crisis and get out of the situation as quickly as possible and mitigate the market risks. Furthermore, investor protection is the key, as such events may incur huge losses for many individuals which may seem completely unrecoverable and force them to leave the market which also have several impacts on the GDP growth of the country.

To battle such events, regulators must keep compliance in check, as these may arise due to illegal practices in the market. Everyone’s regulatory complaint should be monitored on a continuous basis through strong policies in hand.

Risk management procedures should be practiced daily which can prevent such events from occurring in the first place, and if they occur such policies should help combat the risks involved and makes the market stable.Lastly, there are various other ways to battle and overcome the aftereffects of these events. Diversification is very crucial.

Any individual must attain a portfolio by investing in several asset classes which include equities, mutual funds, fixed deposits with securities and bonds to reduce systematic market risks.

Algo trading is future of trading and retailers are opting the automatic way of trading rapidly. But along with the merits of Algo trading, the threats associated should also prompt retailers to make decisions cautiously.

(Views expressed here are personal. Author is Managing Director at Findoc)