Risks of Artificial Intelligence Trading

AI is no longer just a buzzword but a technology that is used widely today. Its real-world applications are wide-ranging, and this is one of the reasons why staying cautious of risks of using AI is important. Especially when you are using AI for trading, you must be extra cautious, as one mistake can lead to significant financial losses.

But what are the exact risks of using AI for trading and how can you overcome them? Well, if you are a trader who is looking for an answer to the same, then read this guide as it has all the details you need. Find not just the risks but simple solutions that can help you avoid them.

Understanding Artificial Intelligence Trading

Artificial Intelligence trading, or AI trading, is the technique of using computer programs to make trading decisions. These programs analyze large amounts of data that can help in understanding past market trends and help predict future market movements better. These computer programs can identify patterns and give buy and sell signals automatically. 

AI trading works by analysing past prices, news updates, and other financial data. It then predicts possible price movements and places trades automatically. This process is much faster than human trading and can handle many trades at once.

However, AI trading is not risk-free as it works on the data that you provide. Any mistake in the same can lead to wrong trading decisions. At the same time, if there are changes in the market conditions due to some unexpected events, it might be hard for the system to adapt its trading strategy quickly. So, though it is helpful, it is important that you know the risks of using AI in trading as well as the solutions to avoid those risks. 

Read Also: How to Use AI for Smarter Investing in India

Typical Risks of Artificial Intelligence Trading

AI trading offers speed and advanced analysis. This can save time and allows the traders to get better insights, which is key to completing profitable trades. But there are risks as well. It uses the historical data, which, if unreliable, might lead to financial losses. But there is more to it. 

Knowing these risks is important for any trader looking to identify positive trades. So, here are the top risks that you must be aware of:

Risk 1: Over-Reliance on Algorithms

AI trading systems can make quick decisions. This is mainly because it is based on a pre-defined algorithm. These algorithmic models are trained using years of historical data to account for every market scenario. However, one major risk emerges when traders depend completely on these algorithms without checking or understanding the trades being placed. 

It works on the set of rules and processes. Now, if there is sudden market news, a policy change, or an unexpected global event, this algorithm may not react appropriately, leading to heavy losses. This risk becomes bigger if traders believe AI can replace their own market knowledge and instincts.

Ways to Avoid This Risk

• Monitor Regularly: Ensure that you keep a watchful eye on your AI trading system, especially during periods of market volatility.
• Set Clear Limits: To avoid the potential losses, ensure that you set stop-loss limits as well.
• Combine Human Insight: Use AI for analysis only and the final decision should be based upon your judgment only. 
• Review Performance: Always check the performance of your AI trading system at regular intervals. 

Risk 2: Wrong Data or Poor Data Quality

AI trading systems rely completely on data. The data that you offer is used by AI for analysis and interpretation. If you use wrong historical data, then the system will generate results that can be incorrect. 

For example, omitting an S&P 500 index rebalancing event will skew backtests and live trade signals. Now, if AI assumes no such event is there, then the chances of wrong analysis and prediction are higher. 

Additionally, data quality issues can arise due to technical glitches or low-quality data sources used for algorithm training.

Ways to Avoid This Risk

• Use Verified Data Sources: Gather the data from reliable sources like company websites, news, or other sources. No data should be taken from unverified sources. 
• Regular Data Points: Check and validate all the data points that you use. Make changes as and when needed.
• System Testing: Before using it for actual trades, ensure that you train and test your AI trading model using multiple datasets to ensure the robust performance. 
• Update Datasets: Continuously update and validate your datasets, ensuring they reflect current market conditions, to keep your AI trading model accurate and adaptive.

Risk 3: Market Volatility

AI trading models work well when the market follows expected patterns. But this will not always be the case. There is a chance that during volatility, the trend and pattern may change. This will make it difficult for the AI to work. At times, these models can fail. 

AI predictions are based on historical data and algorithms that may not factor in unexpected future events. This can lead to rapid losses if the AI continues to place trades based on outdated or irrelevant patterns during such times.

Ways to Avoid This Risk

• Set Volatility Alerts: Set up the alerts that can guide you when to stop trading due to volatility.
• Diversify Strategies: Never just rely on AI trading, but also use your market knowledge to develop other strategies to get better results. 
• Limit Trade Size: Reduce trade volumes in highly volatile markets to minimise potential losses.
• Regular Model Updates: Update AI models frequently to factor in recent market behaviours and adapt to changing patterns effectively.

Risk 4: Technical Failures

AI trading systems use cutting-edge technology and depend on the latest hardware, fast network, and so on. Now, if there is any flaw or failure in any one of these, the entire system will fail to work. This can disrupt trading activities. 

This may lead to missed trades or even wrong order placements. Now, any of these cases can lead to potential losses, which can impact your trading negatively. Such risks are higher when systems lack proper backup and monitoring protocols.

Ways to Avoid This Risk

• Use latest Technology and Hardware: Use good-quality and high-performance hardware equipment to run the latest technology.
• Maintenance and Backups: Follow a proper maintenance schedule and have a backup for the worst.
• Emergency Protocols: Set clear steps for quick manual intervention if the system stops working during active trades.

Risk 5: Overfitting of Models

Overfitting occurs when an AI trading model learns historical data too precisely, mistaking random noise for meaningful patterns. As a result, even minor deviations in real market conditions can cause the model to fail, leading to poor performance in live trading. This leads to poor trading decisions and financial losses. 

Ways to Avoid This Risk

• Use Cross-Validation: Test AI models on different datasets to see how they perform.
• Simplify Models: Make the model adaptable, which will allow you to adapt to changing market conditions better.
• Regular Performance Reviews: Review and update your AI models periodically to keep them updated as per recent market trends.
• Combine with Human Analysis: Use AI as a supportive tool only. Always use human insights to get better results. 

Tips to Use AI Trading Safely

AI trading can be a powerful tool if used wisely. So, if you are new to this, here are some tips for you:

• Know Your AI System: Understand how your AI system works and check the data that it uses. 
• Start with Low Capital: Start with a small capital when testing your AI trading strategy. Once you achieve consistent and reliable results, gradually increase your investment.
• Use Stop-Loss Orders: Profits and losses are part of trading. But it is always recommended to keep a stop-loss to limit your losses, even when you use AI.
• Keep Learning: Stay updated with market trends and AI advancements. Adjust your trading system according to recent updates for better results.
• Monitor Regularly: Never leave your AI trading system unattended for too long. It is best that you check its performance on a regular basis.
• Diversify Strategies: Do not depend only on AI trading systems for all of your trading activities. Combine it with manual trading and other investment strategies for balanced results.

Read Also: What is AI Washing? Definition, Tips, Evolutions & Impact

Conclusion

AI trading can make your trading faster and your decisions smarter. But it is important that you do not over-rely on the same. While AI can help, you need to use your experience and insights too. This will limit the potential for losses and help manage profitability. 

Always consider AI as your supportive tool and should not be considered a replacement for human judgment. Combine both for the best trading results. To strengthen your understanding of trading basics and understand such concepts clearly, visit the Pocketful blog section.

S.NO.	Check Out These Interesting Posts You Might Enjoy!
1	How to Use AI for Smarter Investing in India
2	Scope of AI in Investing: Usage, Benefits, and Challenges
3	Best Artificial Intelligence (AI) Smallcap Stocks
4	Best Artificial Intelligence (AI) Stocks In India
5	What is Quantitative Trading?