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What is algo trading and how does it work? A comprehensive guide

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Introduction to algo trading

Investors across various financial markets, including the crypto market, employ a plethora of trading strategies and continually innovate new ones.

One such innovation is algorithmic trading, commonly known as algo trading. In this piece, we'll delve into the intricacies of this innovative trading method, offering you insights into its workings.

What is algo trading?

Algorithmic trading is one of the forms of cryptocurrency trading. Essentially, it's an automated trading system that operates based on a predetermined algorithm and doesn't require constant involvement from the trader. 

Instead of the trader executing trades, trading bots, specialised software, handle the execution. They continuously analyse the market and determine the optimal moment to open or close a trade.

The evolution of algorithmic trading

It's believed that trading bots first emerged in the USA in the early 1970s, long before the creation of the first cryptocurrency. Initially, these robots were solely involved in algorithmic asset selection. Later, they connected to the exchange terminal for swift placement of specific orders.

The concept itself first emerged back in 1998 when the SEC permitted the use of electronic platforms in stock trading. The early adopters were major players, such as hedge funds.

By the 2000s, technological advancement surged rapidly. While trading bots executed about 10% of trades in the early 2000s, by the end of the decade, their usage had soared to 70%.

Later, more sophisticated technologies appeared, including artificial intelligence (AI) and neural networks. They’ve made bot operations even faster and more refined.

How algo trading works

At the core of algo trading lies analysis. It leverages historical data of your chosen cryptocurrency asset to calculate typical behavioural models and considers current market changes. 

From a technical standpoint, algorithmic trading aims to identify algorithms for opening and closing trades to maximise profits.

Here's how the process looks from the user’s perspective:

1. The user downloads and instals the cryptocurrency trading bot.

2. Then, they configure all necessary settings: select preferred crypto assets, specify desired trade volumes, and set limits on transactions.

3. Upon activation, the bot analyses the behaviour of digital assets and indicator signals. When the programme identifies a favourable trading opportunity, it requests permission from the user to execute the trade.

4. The trading bot provides users with information on all completed transactions in the form of a report.

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Trading algorithms and strategies

Not too complex so far, right? Well, let's delve a bit deeper and see what trading strategies and trading algorithms are. 

A strategy is a specific sequence of actions and a pattern of operation that a trading bot adheres to. Users can devise their own strategy or choose from existing ones – we’ll discuss some later. The bot follows any instruction you select. 

The trading algorithm is a set of instructions that the trading bot follows. It transforms the strategy (theory) into a set of practical actions that will operate in the market.

High-frequency trading (HFT) is the primary form of algorithmic trading. It's the fastest and most popular variant of quantitative trading. The essence lies in executing trades very rapidly, literally within fractions of a second. Consequently, the main advantage of this system is its high speed.

API integration and trade execution

Now it's time to learn a couple more terms to understand how algo trading works.

An Application Programming Interface, or simply API, is a description of ways for different programmes to interact. API integration is necessary for different systems to “befriend” each other and expand each other's functionality, ensuring maximum efficiency.

API solutions in trading help enhance the efficiency and flexibility of trading bots by utilising additional systems and services.

Let's turn to trade execution. There’s nothing complex here – it's simply when a buy or sell order gets fulfilled.

Key components of algo trading systems

An algo trading system isn't limited to just the elements we've already discussed. Here are a few more important concepts you should know about.

The first one is backtesting, which refers to the process of testing a trading strategy on historical data. It's necessary to assess the effectiveness of the strategy in advance: to identify potential profitability and possible risks.

Backtesting is beneficial as it allows you to "test" your strategy without using real money. However, it's important to remember that this process doesn't guarantee the success of a strategy as historical data doesn't always accurately reflect current market conditions.

Order types and slippage

When you trade, you interact with the market by placing orders. These are instructions to execute a cryptocurrency buy/sell transaction. There are several order types in algo trading:

1. Market order. This is an instruction for immediate buying or selling (at the current market price). It's suitable for quick entry/exit from a position but can lead to price slippage.

Price slippage is the difference between the expected execution price of an order and its actual execution price. This can occur due to high volatility or low liquidity in the market. Unfortunately, it's not entirely avoidable. But you can minimise the probability of slippage. Limit and stop orders are helpful here.

2. Limit Order. This is an instruction to wait for the order to be executed until the price reaches a specified or more favourable value. It's executed only at the specified price or better, thus allowing control over the entry/exit price.

3. Stop Order. This order is activated only when a specified price (stop price) is reached. It's mainly used for loss protection or profit-taking. Stop orders come in several types:

  • Stop-loss. This order executes a sale when the price falls below the specified level.
  • Take-profit. This order starts selling when a specified profit level is reached.

Risk management and market efficiency

When engaging in algorithmic trading, it's crucial not to forget about the rules of risk management. To minimise potential losses, it's essential to adhere to several key principles. 

Firstly, a trader should refine their strategy. To achieve this, one can meticulously plan their budget and analyse the chosen crypto assets. It's also a good idea to engage with other traders and learn about the trading strategies they follow.

Remember: even if a strategy doesn't promise any profit, the bot will still adhere to it. That's why giving planning the central role is crucial.

Secondly, a trader'll need to periodically monitor the bot's performance. It's not immune to system errors and may misinterpret market data. That’s why it’s important to keep track of all relevant industry news and strive to stay informed about new trends and sentiments within the community.

Thirdly, an algo trader will also need to be mindful of market efficiency, which refers to the state of the market. This term denotes the degree to which current cryptocurrency prices reflect all relevant market information. 

Advantages and disadvantages of algo trading

So, it's time to sum up. Let's start by looking at the advantages of algo trading, which include:

  • Automation of processes.
  • Elimination of human error.
  • Strict adherence to the programmed instructions.
  • Ability to trade simultaneously on multiple exchanges and execute numerous trades within a short time frame.

As for the disadvantages of algo trading, there are a few as well. Among them are:

  • Probability of errors in the program.
  • If you give a bot a poor strategy, trading may result in losses.
  • No guarantee of profits.
  • Trading bots still require periodic monitoring and control.

Algo trading in cryptocurrency markets

Algo trading in crypto markets has its unique challenges due to the crypto market’s distinct microstructure. Here are just a few of them:

  • Volatility. Cryptocurrencies are much more prone to price fluctuations than traditional finances. Such volatility increases both profit opportunities and risks as digital assets can skyrocket or plummet within seconds.
  • Liquidity. It directly depends on the current trading volume and market activity. Overall, the crypto market is less liquid compared to traditional financial markets, so sometimes it may be challenging to execute a trade at the desired price.
  • Regulation. Currently, the level of regulation in the crypto market leaves much to be desired. Regulatory gaps provide opportunities for fraudsters.

Therefore, the choice of a sound algo trading strategy for crypto largely determines much of your success. Here are the most common strategies:

  • Market making. This trading system maintains liquidity in the market. In this strategy, profit is generated by quickly processing data flows and accounting for them. Such bots earn from the spread, which means the difference between the best bid and ask prices for cryptocurrency.
  • Arbitrage. This strategy involves making a profit from the price difference of cryptocurrencies on different trading platforms. Within this trading system, the trading bot executes arbitrage deals.
  • Technical analysis. Here, the trading bot utilises analytical tools to identify patterns and attempts to predict the best time to enter and exit a trade.

Getting started with algo trading

If all these challenges haven't deterred you and you've decided to move from theory to practice, then keep reading! Our next topic is choosing the right trading platform.

TSLab is an algorithmic trading platform that allows trading on cryptocurrency and stock markets. It enables the creation of trading robots, testing on historical data, and launching bots on real trading accounts.

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TSLab website

The market scanning programme Trade Ideas provides traders with signals about potentially profitable trades. At its core is an AI-based bot.

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Trade Ideas website

Trend Spider is closing our list. It’s a trading bot based on machine learning. It helps traders analyse charts by conducting real-time technical analysis on selected cryptocurrencies automatically.

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Trend Spider website

When you finally settle on an algo trading platform that appeals to you, it's time to start developing or selecting trading strategies. Beginners can begin trading by using any of the strategies we’ve discussed earlier. As for developing your own trading strategy, this method is more suitable for experienced traders who are absolutely confident in their actions.

Beginner algo traders should remember about continuous monitoring and optimization. Yes, a trading programme can analyse an endless amount of data and charts, but it won't be able to respond correctly to market sentiments and expectations like humans can. After all, there are still industries where humans outpace machines!

Conclusion: the future of algo trading

Algorithmic trading is a relatively new method of trading cryptocurrencies. It significantly eases traders' lives, relieving them of the need to constantly monitor the market.

However, at the moment, this technology comes with its own drawbacks and risks. The possibilities of algo trading do not provide a 100% guarantee of success and can lead to losses.

Therefore, the itez team urges you not to forget about the rules of money and risk management. To stay informed about all the latest events in the world of algorithmic trading, don't forget to read our blog!

🤔 Do you want to try algo trading? Share your views in our socials! 

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Here are three other cool articles: 

What is a crypto faucet?

Understanding yield farming

OTC trading platforms

This article is not investment advice or a recommendation to purchase any specific product or service. The financial transactions mentioned in the article are not a guide to action. It’s not intended to constitute a comprehensive statement of all possible risks. You should independently conduct an analysis on the basis of which it will be possible to draw conclusions and make decisions about making any operations with cryptocurrency.

Maria Kachura
Maria Kachura

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