'Begin with a small investment, observe performance, then scale up gradually.'
The Securities and Exchange Board of India's new norms for retail participation in algorithmic (algo) trading will take effect from October 1.
Investors looking to adopt this automated approach must first assess its pros, cons, and risks.
Mixed views
Reactions to the new norms are divided. Some believe they will improve transparency and security.
"These norms promote accountability and reduce risk for retail investors," says Rajesh Ganesh, founder and CEO, TripleInt Trading Systems.
Others fear they could result in higher entry barriers.
"The static IP requirement (a stable Internet address) is impractical, especially for traders who use basic setups or travel. Compliance with these norms will require additional infrastructure like cloud servers, which will raise costs," says Ramakrishnan Selvaraj, cofounder, coinhunt.bot.
Understanding algos
Algo trading involves using pre-programmed computer algos to place and execute trades automatically.
"Algos provide speed and they can handle a high volume of trades. Automation removes emotion from decision-making. Trades only get executed when certain preset conditions are met, which reinforces discipline," says Ganesh.
Investors need to understand the difference between white- and black-box algos.
"In white-box algos, the logic behind trade decisions is visible to users.
"In black-box algos, the reason why a buy or sell signal was generated is not disclosed," says Ganesh.
White-box models are more transparent. But most providers offer black-box versions to protect their proprietary strategies.
Sebi's norms permit only registered research analysts to offer black-box algos.
Avoid algo with high drawdown
Ganesh suggests reviewing back-tested performance across varied market conditions to assess a strategy's robustness. He adds that drawdowns should ideally not exceed 20 to 30 per cent.
Investors should also check risk-adjusted return ratios like Sharpe and Sortino. Trading frequency also matters.
"More trades can lead to higher costs and hence lower net returns," says Ganesh.
Warning signs
Investors must seek at least one year of back-tested data.
"Short-term, cherry-picked data may hide significant losses," says Selvaraj.
Algo providers must disclose net returns after factoring in taxes and transaction costs, and must incorporate a realistic trade failure rate in the results they show.
"Before selecting an algo, confirm that orders are actually being placed on an exchange through it. This will help you avoid fraudulent algos," says Vikas Singhania, CEO, TradeSmart.
Mistakes to avoid
First-time investors invest small amounts without understanding the strategy. When they lose that money, they invest more to try and recover the original amount.
"Begin with a small investment, observe performance, then scale up gradually," says Selvaraj.
Singhania warns that overleveraging can result in massive losses. Many investors do not check back-tested data and rely purely on an algo's popularity.
"This tendency to follow the herd without doing due diligence often leads to losses," says Selvaraj. Not monitoring an algo is another common mistake.
"Even automated systems require human supervision. Sometimes, technical issues can arise that may require manual intervention," says Singhania.
Selvaraj advises using brokers with reliable application programming interfaces (APIs).
Algo trading suits those who favour disciplined, rule-based decisions.
"Users need to have a fundamental understanding of how logical conditions work," says Trivesh D, chief operating officer, Tradejini.
He adds that algo trading is capital-intensive, hence investors must have a minimum Rs 10 lakh, plus some buffer.
He suggests that those who prefer a hands-off approach, get anxious in volatile markets, or are overwhelmed by things like setting up the system, back-testing, and trade analysis should avoid algo trading.
Tips for controlling risk
- Define maximum exposure per trade and total capital allocated to the algo
- Use a kill switch to halt all trades instantly if required
- Implement throttling to restrict order volume per second or minute
- Set stop-losses and circuit breakers at both individual trade and portfolio levels
- Define a daily loss cap to trigger automatic shutdown after a certain amount of loss
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Any use of the information/any investment and investment related decisions of the investors/recipients are at their sole discretion and risk. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Opinions expressed herein are subject to change without notice.
Feature Presentation: Ashish Narsale/Rediff
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