What are trading bots?
Trading bots are simply programs that watch market conditions and place trades based upon predefined algorithms, allowing for automated and often high-frequency trading to occur.
Traditional financial markets have been using automated systems to trade assets for decades now, and it is currently estimated that 80% of the stock market is controlled by machines. Essentially, a trader can create programs based around a trading strategy, which then watch the market 24/7 and place trades following the defined algorithm. Obviously, this still means users need a solid strategy and the market needs to be favorable to that, but when used correctly means that traders don’t need to watch the market 24/7 to keep an eye on their positions.
Additionally, using computers to make trades means that they can respond thousands of times faster than a human ever could, which opens up the possibility of strategies that a regular trader could not utilize on their own. This is referred to as “High-Frequency Trading” and it has become fairly common among high-end users. When you combine all of this with the fact that these assets are natively digital and the markets are always open, it is no surprise that using bots has come to the world of cryptocurrency in a big way.
What different types of bots are available?
There are really as many types of bots as there are potential strategies, but some common ones include trend-following bots, arbitrage bots and scalping bots.
Trends are pretty much the essence of what many traders look for when they make their strategies, and bots that are designed to follow trends basically automate what a good trader should be doing anyway. Based upon which way the market is going, trend bots buy and sell when it is, theoretically, optimal to do so. The bots use math and market data, so they can fail if not well designed, but if properly “trained” they should have a trader coming out ahead more often than not.
Arbitrage bots attempt to make profits by taking advantage of price discrepancies across multiple exchanges. The programs track prices of assets from many different markets, and if for example Bitcoin is going for a slightly higher price on one exchange and lower on another, then the bot can quickly purchase the lower priced coin and turn around and sell it for a small profit. These differences in price are quite common, but they don’t last long. In fact, the rise of these bots has made it much more competitive out there and arbitrage opportunities are believed to be becoming less frequent as a result.
As opposed to following a trend, scalping programs work better in sideways markets. Scalpers try to make their money by purchasing and selling across the bid-offer spread, buying at the bottom and selling at the top. These spreads can be as little as a few pennies or less, but if the process is automated and the positions are big enough, real returns can be seen this way, making this strategy another one that has become quite popular for traders who utilize bots. Of course, like with arbitrage, this too has become fairly combative, with often only the fastest systems able to take advantage of these spreads before they change.
What makes the cryptocurrency market attractive to algorithmic traders?
There are many elements of trading in cryptocurrency that make it a hot-bed for bot trading. For example, these markets are natively digital, open 24/7, and much smaller than their traditional counterparts.
Digital assets by their very nature are a logical choice for traders who deploy bots. For one, because the assets themselves are completely online, so too are the exchanges. Having completely automated platforms makes bot integration simpler, and it also doesn’t hurt that these markets never close. This means there are always opportunities available all day, every day, which is something a human trader could never fully take advantage of.
It also doesn’t hurt that, due to the much smaller size of the digital asset world compared to traditional markets, it can be notably more trivial to have an impact on prices than it would in something like the stock market. With the aid of bots, one or a small group of participants can potentially influence price action either to their benefit, or to the detriment of the market as a whole.
More on that shortly, but know that most bots are simply looking for opportunities to make a profit for whoever is deploying them. For example, in late 2017 there were discrepancies as high as 30% between South Korean exchanges and US-based ones. This can happen for a variety of reasons, not the least of which can be related to inconsistent regulations under different governments. Whatever the cause, the aforementioned arbitrage bots are perfectly suited for just this type of chance for profit.
What are the positive effects of these bots on the cryptocurrency market?
Trading bots obviously benefit the individuals using them, but also help markets move more efficiently and bring in much-needed liquidity.
A healthier, more inclusive market
Why a trader may want to use a bot is probably obvious now, but the benefit to cryptocurrency as a whole is arguably quite large. These types of tools are usually only accessible to major financial institutions, but now virtually anyone can start getting involved. This brings cryptocurrency another step closer to levelling the playing field between those in economic disparity. As for the health of the exchanges, advocates of automated and high-frequency trading maintain that these systems actually make the whole market more efficient. The aforementioned price variations across different exchanges disappear quickly, and it would be fair to say in general that price discovery happens faster than without bots. In just the last few years, the average price spreads across exchanges have dropped dramatically, and many attribute this to an increase in HFT bot usage across the board.
Greater liquidity can lead to more institutional interest
One other area where algorithmic trading is enhancing the market is liquidity. Liquidity means having sufficient buyers and sellers so that traders can have faith that they can make a trade when and where they need to. One important source of liquidity is market makers, which are basically entities that place both buy and sell offers across the bid-ask spread, and they make their profit from the difference. When this strategy is done in a high-frequency fashion using algorithms, it can increase profits for the party using it but also boost liquidity. This can then attract more big investors, which will further expand the market, creating a positive feedback loop based upon this effect. That being said, having countless bots running all day, every day can also potentially create problems for the market, as well.
What are the negative effects?
While bots can be a great tool for many traders, some are concerned about the ways this could create room for manipulation, such as with “pump and dump” scams as well as decentralized exchange (DEX) manipulation.
Bots can manipulate exchanges
Using a series of bots to bring added liquidity to exchange sounds harmless enough at first, as it should simply create a better user experience for clients. However, if the vast majority of trading activity on an exchange is bots, then that could be a red flag that something isn’t right. Using bots to simulate real trading activity in order to make an exchange look more active is known as “wash trading” or “slippage.” It is illegal in traditional markets, but much of the cryptocurrency landscape is still unregulated, so it certainly happens. It has even been speculated that as much as 95% of cryptocurrency volume on some exchanges could be suspect.
There have also been issues with automation on decentralized exchanges, though not just with wash trading. It has been observed that HFT bots have been “front-running” on various DEX’s, a practice where the programs place incrementally higher fees to ensure their trades are given priority. By using an automated, lightning fast system, it becomes impossible for any human player to compete.
Pump and dump scams are common
Another way bots may be hurting cryptocurrency comes in the form of what are known as “pump and dump” scams. Using bots, the scammers basically make it look like one coin or another is beginning a bull run. This doesn’t necessarily have to be that far of aprice move either, as usually these scams occur to small cap coins that haven’t moved much in a while. When regular traders see that the price has risen a bit, it often starts to induce a certain level of FOMO that can then pretty much feed off of itself. Frequently the perpetrators combine this artificial pump with some form of social media campaign as well, to really get people excited. Once the coin has seen sufficient rise, the originators sell and let the market inevitably collapse sooner or later, as the “bull run” was never built on anything but hype and market manipulation.
In a similar vein, “flash crashes” are also an issue. This is when a sudden drop in price can trigger a whole series of bots, further pushing down the selloff, triggering more bots, and this can then create a cascade effect. In May of 2010 an event just like this took place in the stock market, seeing the Dow drop 1,000 points in mere minutes. Ultimately, it was just this sort of runaway automated effect that was found to be the culprit. Not only is cryptocurrency susceptible to this, the previously mentioned fact that it is a much smaller market makes it even more of a likelihood.
Institutions can get unfair advantages
Lastly, there are massive institutional players who also leverage the power of automated trading, but often have an advantage over retail users thanks to something called colocation. Colocation is a service offered by some large firms that allow businesses to rent and host servers at the same site as the exchange with direct connections to the trading systems. This means these clients have the absolute fastest ability to post orders, completely outclassing those without the service. Of course, these accounts can be quite pricey, which can leave many retail investors well behind.
How to get involved?
If using bots to automate your trades sounds like something you would be interested in exploring further, there are many resources available. You could certainly begin by digging into different trading strategies and see what bots are available that cater to them. If you really want to get your hands dirty you can of course even build your own, however this is mostly for users with a high degree of both programming knowledge as well as trading expertise.
For a beginner, it may be wiser to go with a service that can help walk you through some of the choices involved with trading bots. Just answer some questions about what you want to trade and where, and the systems can even come up with the most profitable strategies available based upon current market conditions.
By using bots that have been curated by professionals and taking the time to understand how they work, traders certainly have the potential for a new way of handling their trades. Like any other tool, bots don’t just equate to success, but they certainly can make success more lucrative. Seeing as it doesn’t look like these programs are going away anytime soon, users may want to begin learning more about bots, as they’ll likely be shaping the cryptocurrency market for years to come.
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