What Is a Trading Algorithm and How It Works
What is a Trading Algorithm?
Algorithmic trading is a process which involves using computer software and systems to make market trades based on predefined strategies which execute automatically. They are commonly referred to as “bots”. The term is broad and can incorporate anything from a simple trading script developed individually to the multimillion-dollar systems employed by HFT Quant Funds on Wall Street.
There are a number of advantages that these algorithms have over manual trading. The first and most obvious advantage is that these algorithms can operate 24/7 without tiring or needing a break. The second advantage would be the speed with which they are able to make the trades. These bots run on high-performance servers that are able to open and close trades in a matter of seconds. These systems are based only on codes, meaning there is no emotional component when these scripts place their trades. While traders might get anxious and panic sell or make bad decisions, the bot sticks to its set strategy no matter what happens.
How do Trading Algorithms work?
Trading algorithms are usually coded in recognized programming languages such as Python, Nodejs, R, and C++. These pieces of software run on dedicated machines that connect to an exchange’s API and uses the price feeds as inputs to the model. The resulted outputs will be orders.
In order for them to work efficiently and generate profit, the market must present three important features:
Strong Liquidity: Liquidity is required in the order books if you will be having a bot placing trades at certain levels. There can be issues when you have wide bid/ask spreads and the trading algorithm has enormous order slippage. This will cause great damage on any automated system and perhaps it is the reason why bots do not perform well on low volume low market cap altcoins.
Open Access: This involves the bot’s access to the exchange’s order books. Although most cryptocurrency exchanges have integrated API functionality, they do also come with some limitations. As an API has more limitations, it restricts your access to information and makes it less effective.
Emerging Market: The less competition you have from other trading algorithms the higher profitability rate you’ll obtain. As you enter more competing bots on the market then you will have to improve the speed and efficiency of your bot. This is also more applicable when it comes to implementing strategies that are arbitrage-related.
There are a number of crypto trading strategies you can develop using trading algorithms:
– Arbitrage Trades
Considered to be one of the most favorable trading opportunities that exist for crypto trading algorithms, arbitrage trading, takes advantage of market mispricing and earns a risk-free profit.
There are plenty of arbitrage opportunities in the markets which can be found across exchanges and even within them. In order to take advantage of these opportunities, you must move quickly. They only occur for a few seconds before a market realises that there is a mispricing and updates the prices.
In the cryptocurrency markets, the arbitrage trades that make the most profit are those that trade coin price variations on different exchanges. As a result, this will require the bot developer to own accounts on both exchanges and to connect the orders from the algorithm up to their API systems.
– Order Chasing Bots
Order chasing place the trades expecting an order flow that is about to come from much larger buyers/sellers (institutions).
Order chasing based on insider information is illegal (named “front running”). This means, that if a broker who knows that its client is about to make a large order and enters trades before them, they are trading on insider info and could be sanctioned by the SEC.
However, if an algorithm that is able to determine order flow before the other traders by using information that is publicly available, then it is acceptable. This case requires that your algorithm will move incredibly fast in order to adapt to market news effects before your competitor is able to redress its own algorithm.
Currently, the number of large institutions trading in the cryptocurrency markets is limited and those that do participate usually trade in the OTC markets by purchasing larger blocks. However, you can still generate decent incomes from order chasing large retail demand.
Mean reversion trading strategies
– Standard Deviation Reversion
The concept of a standard deviation is a familiar term in the field of statistics. This is the notion of an average movement away from the statistical mean and it is used to model abnormalities in data.
From a trading perspective, the most important data points are that of 2 standard deviations. These are used to model the Bollinger Bands around the trading pair’s shifting average.
– Pairs Trading
Mean reversion trading is not only applicable to one asset but can also be used when trading the variation between two different assets.
The idea is that if two assets have been trading with close value movements in the past as well as if there is a reversion away in that historical relationship then the two assets are expected to also revert back.
The trader will then have to sell the asset that is “overpriced” and purchase the under-priced one. In this situation, if the prices do revert, a profit is made. Furthermore, traders are less exposed to the general market fluctuations as they have one asset position long and the other short.
However, it is imperative that these assets have the same regular exposure to the wider market. For instance, common pairs trading strategies use two stocks in the same industry. With cryptocurrency trading, one can easily make use of the historical relationship between two different digital assets to make trades. They will have a rather tight connection with general crypto market movements which means that the trader is rather protected against adverse market moves.
While crypto trading using algorithms has become more competitive in the past months, there are plenty of opportunities that traders can use to generate a decent profit.