AI-driven stock trading is a double-edged sword

Forget trawling through financial data, following your ‘gut feeling’, or perhaps even your fund manager. Artificial intelligence (AI) is changing the way stock trading is done.

AI-driven real-time data analysis can do much more than flesh-and-blood stock traders. It can look into patterns and statistics from the past and process vast data sets to help investors build diversified portfolios.

The unmatched ability of AI-powered machine learning and predictive analysis to assess vast amounts of financial market data accurately has transformed investing techniques and made trading more data-driven and efficient.

Real-time data analysis capabilities of AI systems allow traders to spot patterns, move quickly and react to market changes faster than human traders. For example, AI can analyse stock trends, detect patterns such as consistent price increases over several days and use this data to recommend optimal buying times.

AI algorithms can evaluate thousands of stocks simultaneously, yielding more insights than analysts can.

AI also closely monitors public sentiment by analysing information from news sources, social media sites, and financial reports. For example, if a company announces a significant technological advancement, AI can identify it and recommend purchasing the stock, anticipating that the positive news will drive up its price. Conversely, negative news about a company may lead AI to recommend selling the stock before its value drops further

AI can also help investors identify and capitalise on arbitrage opportunities. Arbitrage is an investment strategy in which an investor simultaneously buys and sells an asset in different markets to take advantage of a price difference and generate a profit.

Here, AI can determine when a particular stock is being bought at different prices by looking into different trading platforms. Then, it would recommend buying that stock at a lower price and selling it instantly to exploit this differential pricing.

Besides trading, AI also helps in portfolio management. It continuously measures performance of stocks and provides recommendations for adjustment according to market conditions.

Advanced neural networks

The use of various AI techniques in stock trading can enhance the effectiveness of investment decisions. For example, AI's ability to predict stock prices is greatly improved by advanced architectures such as Long Short-Term Memory (LSTM) networks, which excel at processing temporal data.

These networks retain short-term memory of recent events for immediate decision-making while maintaining long-term memory for future predictions. LSTM, a specialised type of recurrent neural network (RNN), is designed to recognise patterns in time-series data like stock prices. It effectively retains important past information while filtering out irrelevant details, leading to more accurate stock price predictions.

LSTM’s ability to detect complex patterns in stock price trends makes it a powerful tool for forecasting. Researchers have further enhanced prediction accuracy by integrating genetic algorithms with the LSTM model. While LSTM identifies long-term trends, genetic algorithms optimise model parameters, allowing the system to better adapt to dynamic market conditions.

Genetic algorithms are optimisation techniques inspired by natural selection. They mimic biological evolution by generating multiple possible solutions, evaluating their performance and refining them through processes such as mutation and crossover.

This iterative approach helps identify the most effective trading strategies and parameter settings.

For example, if a stock consistently rises after quarterly earnings reports, LSTM can detect this pattern. Genetic algorithms then optimise investment timing and allocation, helping traders maximise returns.

By combining LSTM’s ability to recognise long-term trends with the adaptability of genetic algorithms to market fluctuations, stock predictions become more precise and dynamic.

Moreover, adaptive risk management systems that use real-time market data can update portfolios dynamically. This helps ensure investors take on an appropriate level of risk while minimising losses. By automating data processing and decision-making, these systems also reduce operating costs for both individual and institutional investors.

Risks of a black box system

Despite its advantages, AI trading comes with several risks.

One of the major concerns is the lack of transparency in AI decision-making. Many of these 'black box' systems operate without revealing how they arrive at trading decisions, making it difficult for investors to understand or justify their actions.

This lack of clarity can lead to accountability challenges — if an AI-driven trade results in unexpected losses, it can be hard to determine whether the issue was due to a flaw in the model, bad data, or unforeseen market conditions.

A similar concern exists with algorithmic trading in general. For example, during the flash crash in 2010, automated trading systems rapidly sold off stocks, causing extreme market volatility. Although AI was not directly responsible, this event highlighted the risks of uncontrolled automated trading, where rapid, opaque decision-making can lead to large-scale disruptions.

As AI continues to play a bigger role in financial markets, ensuring transparency and accountability in trading algorithms becomes even more critical. Hence, AI systems should emphasise explainability through documentation and regular audits.

AI may also not be able to predict unexpected events such as a financial crisis or an uncertain geopolitical environment. To address this, it must incorporate real-time data, apply adaptive learning and operate under human oversight to make more accurate and informed decisions.

Software errors are another threat, especially in algorithmic trading such as high-frequency trading. This approach uses powerful computer programmes to execute a large number of trades within fractions of a second, capitalising on small price discrepancies. Proper testing, continuous monitoring and backup mechanisms are essential to ensure minimal errors in the process.

AI platforms also handle sensitive financial data, making them susceptible to cyberattacks. Implementing strong encryption and multi-layered security measures can help mitigate these risks.

As AI’s role in stock trading expands, investors and traders must be aware of potential risks and adopt proactive mitigation strategies to ensure AI’s reliability in financial markets.

Leading firms such as Goldman Sachs and J P Morgan have already adopted AI and machine learning to enhance trading, optimise portfolios and improve risk management.

AI is increasingly being considered the future of investment. However, as these technologies evolve, regulatory frameworks must ensure ethical, transparent, and responsible AI usage in trading.

(Kiran Khatter is Professor, BML Munjal University. Her research interests include fuzzy theory, neutrosophic sets, image processing, and nature-inspired algorithms.)

This article was first published under Creative Commons by 360info.

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.