Algorithmic trading, or trading by algorithms, is an entirely automated process of trading which does not require human input. All algorithmic trading is handled by computers with complex software programs, able to interpret what orders to use, how much should be committed to such positions and when such orders should be exited.
Algo trading has worked in traditional markets where there is a lot of volume and where processes are regulated. The big question is whether such trading styles can be used for the crypto markets, which for the most part still continues to operate like the wild, wild west.
Algorithmic trading can be used in the cryptocurrency markets. In fact, there seems to be far greater potential for algorithmic trading in cryptocurrencies than in other markets. Most exchanges have APIs which enable traders to build their own algorithms that can interact with these exchanges. Furthermore, the crypto markets have certain advantages that make them more amenable to algorithmic trading than other markets. There is greater volatility, price swings are larger, and the market is pretty virgin with little institutional involvement, which provides a level playing field for even the smallest of players.
When it comes to the cryptocurrency markets, algorithmic trading does not cover only buy or sell situations; there is a lot more that can be done using algorithmic trading. For instance, algo trading in cryptos can be applied in the following situations:
Let’s look at these one after the other.
The cryptocurrency markets allow anyone to be a market maker. How does this work? A market maker in crypto trading provides greater liquidity in a crypto asset by providing both buy and sell orders on a crypto exchange. A market maker does not want to profit from price movements in any direction: they are only interested in profiting from the bid and ask prices they have provided. For instance, I may decide to place a buy order for 100,000 units of a coin known as EDMC at 0.234, and also place a simultaneous sell order for 100,000 units of the same coin EDMC at 0.240. My profit as a market maker is 0.240 – 0.234 = 0.006. Multiply this by 100,000 units and I have $600 in profit. All that is needed is for me to buy off someone else’s sell order at that price, and also to sell off that order at a higher price. Typically, it may not be easy to find buyers or sellers of such large quantities in a crypto asset all at once. But by layering these orders in such a way as to maintain the 0.006 spread, it will enable the market making entity continuously effect these transactions until capacity is reached. This can only be done efficiently and effectively using an algorithmic trading system.
The cryptocurrency market is not a perfect market. There are hundreds of exchanges that derive their pricing from different ways, usually according to local supply and demand. Therefore, you may find a cryptocurrency trading at a particular price on one exchange, and trading at a different price on another exchange. This differential in pricing allows for the arbitrage trading opportunity. But here’s the snag: trying to profit from the price differentials using manual trading techniques does not maximize the opportunity. Sometimes, arbitrage opportunities only last for a few seconds. Algorithmic trading represents the best way to benefit from such price differentials. Speed is usually of the essence and this is where arbitrage trading algos can make a difference.
This has been a traditional use of algorithmic trading in the other financial markets, especially the stock and forex markets. This is done usually when there are very large orders that cannot be fulfilled at one execution venue. Order routing to other exchanges is also desirable if the order volume is so large that execution in one venue can either overwhelm the capacity of that venue, or can cause a massive price shift in that asset. Algorithmic order routing is also used to average out pricing by getting fulfilment at the best possible prices across various execution venues.
As far as the crypto markets are concerned, order routing is quite important because trading volumes are not the same and it may be hard to see one crypto being traded on only one exchange in the volumes that a trader may desire. Hitting an exchange with lower trade volumes using large orders could eat into one side of the order book, which could lead to front-loading of orders with an accompanying increase in price. This could distort the strategy of the trader as he or she may end up buying various chunks of a crypto at wide price ranges. This can be prevented by using an algorithm to route the large orders through several exchanges, ensuring that order fulfilment is not hampered by lack of execution capacity. It also prevents front-loading by experienced traders who are able to read an order book to know when a large order is coming.
A well-constructed smart-routing algorithm can connect to several exchanges from a single wallet, using the various APIs of the exchanges, and from there, route all orders to the exchanges and receive the executions and acquired cryptos into the original wallet. Such an AP can also assess the exchanges to know which ones have the required liquidity to handle such orders. Trying to manually assess hundreds of exchanges to source those which fulfil the order execution criteria is simply impossible.
There are other applications of algorithms to the crypto markets, but the three mentioned above are about the most profitable when it comes to actually using algorithms to make money on the markets.
It must be said that algorithmic trading is not some kind of golden fleece that can be used to make money like an ATM from the crypto market. You have to put in the work to define the parameters that you want to use it for. For instance, as regulation comes into the markets as from 2020, arbitrage opportunities that existed three years ago may be hard to come by. You would have to fine tune whatever strategies you had before to keep making money from them using algo trading.
So you have to put in the work to define and program your algorithms, fine-tune them and constantly tweak them to reduce risk and improve your outcomes in the crypto markets.