Automated trading – operational risk and regulatory limitations

Operational risk is the risk of direct or indirect loss resulting from inadequate or failed internal procedures, people, and systems, or from external events (Bank for International Settlements, Basel Committee on Banking Supervision, Operational Risk Supporting Documentation to the New Basel Capital Accord (Basel: BIS, 2002), p. 2, https://www.bis.org/publ/bcbsca07.pdf).

Since, in this book, we will talk mostly about developing trading algos with Python and not about running a trading business, the main operational risk in this context could be that you don’t follow your own strategy or intervene in the algorithmic trading process discretionarily.

Another risk that may be considered operational (although it is normally considered as money management) is the improper use of leverage. In essence, leverage is a credit line provided by the broker that allows you to buy more than you have in your account. If the leverage is too high, you are at risk of being unable to enter the market, or in certain cases, even worse – liquidating your positions that are rapidly losing money.

Broker risk can also be attributed to operational risks as the broker is the very entity that provides you with access to the market, gives you a credit line to open positions, and does the clearing and settlement. Some brokers also act as market makers for their clients, netting their positions internally and acting as the counterparty for their own clients, which may lead to a conflict of interest, and even worse – loss of money if the broker didn’t have sufficient capital to perform these operations.

Last, but not least, we should note that algorithmic and/or automated trading may be fully or partially prohibited in certain jurisdictions. So always check with the respective market regulators to make sure you can run your algo trading at all.

Key takeaways

Always perform a background check of all counterparties, especially your broker. Be careful with leverage and check local regulatory documents on algo trading.

Enough on operational risk – at least for a quick start – and let’s move on to another kind of risk that is common for any trading activity but becomes particularly problematic for algo trading: the risk of basing trading decisions on incorrect market data.