Algorithmic trading is executing a large order (too large to fill all at once) using automated pre-determined rules. Cryptocurrency traders use algorithms to make informed and timely decisions when trading digital assets. In this article, we will discuss some popular cryptocurrency trading techniques based on algorithms.
What Cryptocurrency Trading Is and How It Works
Cryptocurrency trading is buying and selling digital assets to generate profits. It involves using strategies and tools to buy and sell cryptocurrencies at the right time.
Cryptocurrency trading is a complex process, and it is crucial to understand the basics before beginning. To begin with, here are some key terms that every trader needs to know:
- Market order
A market order is to buy or sell a security at the best available price.
- Limit order
A limit order is buying or selling a security at a specific price or better.
- Stop-loss order
A stop-loss order is an order to sell a security when it reaches a specific price, designed to help traders limit their losses.
A pair is a combination of two cryptocurrencies traded against each other.
An exchange is a digital marketplace where traders can buy and sell cryptocurrencies.
- Order book
An order book lists all the orders that have been placed for a particular security.
- Depth chart
A depth chart shows the quantity of a security available to be bought or sold at different prices.
A bid-ask spread, most frequently known as just the spread, is the difference between the highest price someone is willing to pay for a security and the lowest price someone is willing to sell it for.
Now that you know some basic terminologies, let’s look at some popular cryptocurrency trading techniques based on algorithms.
The Different Types of Algorithms that Can Be Used for Trading
Many different types of algorithms can be used for trading. Some of the most popular ones include:
Market-making algorithms place orders to buy and sell a security to capture the bid-ask spread. This algorithm is designed to make a profit as the spread between the bid and ask prices widen.
Arbitrage algorithms take advantage of price differences in different markets. For example, suppose one market sells a security for $100, and another sells the same security for $105. In that case, the arbitrage algorithm will place an order to buy the security in the first market and sell it in the secondary market, making a $5.
- Pairs trading
Pairs trading algorithms seek to profit from price discrepancies between two closely related assets. For example, if one asset is trading at $100 and another asset is trading at $97, the pairs trading algorithm will place an order to buy the first asset and sell the second asset.
Rebalancing algorithms seek to keep a portfolio of assets balanced. For example, if the original asset allocation was 60% stocks and 40% bonds, but the stock market has increased by 10%, the rebalancing algorithm will sell some of the stocks and buy more bonds to bring the portfolio back to its original allocation.
- Trend following
Trend following algorithms seeks to profit from trends in the market. For example, if a security price increases, the trend-following algorithm will place an order to buy the security.
- Momentum trading
Momentum trading algorithms seek to profit from momentum in the market. For example, if a security has been rising in price for several days, the momentum trading algorithm will place an order to buy the security.
How to Find the Suitable Algorithm for Your Needs
Many different types of algorithms can be used for trading. The best way to find a suitable algorithm for your needs is to test different ones and see which one works best for you.
When testing an algorithm, it is vital to backtest it on historical data to see how it would have performed in the past. This will give you an idea of how the algorithm performs in different market conditions.
It is also essential to paper trade the algorithm before using it with real money. Paper trading is when you simulate trading with real money without using your own money, allowing you to test the algorithm in a risk-free environment. Once you have tested the algorithm and are confident in its performance, you can start using it with real money.