What Are Trading Bots And How Do They Work?
Richard Donchian proposed the idea of an automated trading system in 1949 but it took 30 years for the system to become commonplace. As Bitcoin and crypto trading grows in popularity, trading bots are now in demand.
Cryptocurrency is a volatile market and traders depend on quick transactions to make a profit. Assets are bought and sold repeatedly. A minor delay can cause huge losses for the trader. Also, a trader can easily make mistakes which makes trading bots necessary.
Novice crypto traders often find trading bots difficult to use and even experienced traders have occasional trouble using bots. In this article, I will explain the basics of trading bots and help you get familiar with how bots work.
What Is A Crypto Trading Bot?
To trade manually, you have to know a lot of market statistics. You would have to know the volume, price, orders, and several parameters and would need to monitor the market closely to figure out the best time to buy or sell crypto.
This is a tedious process and even the best crypto experts would not make much profit. Prices of cryptocurrencies change in milliseconds, rising or falling rapidly. Also, the crypto market never closes — it runs all day, every week.
If you choose to trade this way, it would be a very stressful, full-time job. Hence, you need a trading bot.
A crypto trading bot is a computer program that automates the entire trading process. It can interpret market statistics, predict risks and make decisions whether to buy, sell or hold your assets.
Most importantly, it does this just as fast as the market prices change, which means dozens of trades per minute. With a trading bot you probably would’ve just carried out a trade — or two! To put it simply, you are hiring a super-fast expert to trade for you while you watch your profit grow.
Features Of A Trading Bot
The following features are common to all trading bots
Backtesting
Strategy Implementation
Execution
Job Scheduling
Backtesting
You can only learn crypto trading by trading, but you could lose a lot of money in your trading account that way. Trading bots provide a solution by simulating how good (or bad) a trading strategy is in the real market. It does this using collected data on trades done in the past. This is called backtesting.
Strategy Implementation
A trading bot might be more efficient than a human but it still needs a human to provide it with a strategy. A trader needs to specify the strategy that the bot would use to determine when and what to trade. With the strategy provided, the bot would be backtested to know how the strategy performs.
Execution
It is time to use your trading bot in the real-time market. The strategy that you coded into your bot is sent to the exchange as API requests. The exchange decodes it and allows your bot to use it for trading.
Job Scheduling
The primary function of a trading bot is to automate the entire trading process. After the bot has been tested and works efficiently, a job scheduler is set up. The job scheduler enables trades to be done automatically.
How does a trading bot work?
The working mechanism of a trading bot is divided into three parts.
Signal Generation
The job of the trader is done in this phase. At one end of the signal generator, market data is sourced and interpreted. Based on the data, a buy or sell signal is given at the other end.
Risk Analysis
This is the critical part of a trading bot. Market data is used to predict the potential risks of trade. Using the information and parameters set by the trader, the bot decides how much capital to allocate to a trade.
Execution
Buying and selling are done in this stage. The signals received from the signal generator are converted into API requests. It is then sent to the exchange to be processed.
Types of trading bots
There are four main types of trading bots which are listed below.
Arbitrage bots
Market making bots
Technical trading bots
Profile automation bots
Arbitrage bots
Arbitrage is a strategy used by crypto investors in which cryptocurrencies are bought on an exchange then quickly sold on another exchange for a higher price. An arbitrage bot like bitsgap utilizes arbitrage to make a profit.
Market making bots
These bots make a profit by placing several buy and sell orders at the same time. The sell order is significantly higher than the buy order.
For instance, if BTC sells for $1, the bot would place a buy order for $0.9 and a sell order for $1.01. A profit of $0.02 is then made. This figure is multiplied by the number of orders placed.
This is the scalping strategy and these bots are also called scalping bots.
Technical trading bots
3Commas is a popular example of this type. Technical trading bots make price movement predictions using indicators and signals. The bots use these predictions to trade just before a price increase which creates profit.
Profile automation bots
Unlike other bot types, profile automation bots do not generate profit. Instead, the bots are used to automate repetitive and boring tasks such as rebalancing your portfolio. Hodlbot is a well-known automation bot.
Advantages of trading bots
Efficiency
Trading bots are not prone to human errors or delays. With the correct data and algorithm, it can trade your assets and has a better chance at making a profit. It can also work non-stop and keep up with the never-closing crypto market.
Emotionless
Humans can make wrong decisions out of greed or fear of losing capital. Trading bots do not have such drawbacks.
Powerful
Trading bots can process more trades than humans because of their ability to handle large quantities of data better and still reach practical conclusions.
Disadvantages of trading bots
The main disadvantage of trading bots is that they are not suitable for highly unpredictable markets. Unexpected market drops can greatly affect trading. Therefore, traders should rely more on their instincts than the bots.
Trading bots are also quite expensive but some bots can be obtained for free.
Although trading bots are not perfect tools, they are essential for a trader’s success. Bots relieve you from the burden of repetitive tasks and can also benefit you if you want to be a part-time trader.
Choose the trading bot that satisfies your requirements and research before you begin trading — you can also build your bot or use customizable bots!
