An Inside Look into Trading Bots and The Way They Work

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By Jacob Maslow

Humans are fragile creatures. They are a mass of emotions, biases, and prejudices. Not, then, the ideal recipe for making cold, ruthless, and unsentimental judgment calls when it comes to trading.

No matter how detached stock, crypto, or forex traders claim to be, they will always have blind spots and psychological traits that run counter to the impersonal logic volatile markets require. That’s where trading bots come in. These are AI-driven pieces of software that scan the market and make trades to a pre-set list of conditions.

But would you put your life – and your shirt – in the hands in the robotic hands of an algorithm? Is it safe, and how do they work in practice?

If we look under the hood of a trading bot, it consists of three components: the generator, the risk function, and the trade execution element. They work together to crunch market information, spot trends, and make trades based on the generator’s predictions and the risk calculations.

Speed, particularly in volatile market situations, is the trading bot’s forte. They are instrumental in having in your corner, no matter whether you are a newcomer or an experienced trader.

However, trading bots are not a shortcut to profits. If they were, everyone would be using them, and we could all abandon our screens and go for coffee.

But trading bots are no guarantor of profits; instead, they are means to more consistent trading and better outcomes. The trading bot is driven by signals and ultimately an unemotional and clear-headed compadre. A tool, in reality, that will give you an edge and help ensure you maximize trading opportunities by taking the human element out of the equation.

Take crypto-currency trading as an example of a volatile and dynamic market. In a crypto market that’s falling, a bot might trigger a rapid trade to sell and cut your losses. Equally, another bot might well err on the side of caution by selling only a proportion of your position and hold the remainder in the expectation of a market improvement.

In theory, both of these bot-driven trades are better results than if a human opted to hold the position or scrap all of the crypto rather than sell off a percentage.

Like humans, all trading bots are different. Some bots demonstrate better success rates than others. While bots can trade consistently, they lack insight and intuition. They are, therefore, tools of the trade rather than a replacement. Sure, they are fast and can analyze markets quicker than humans. But they are never going to be a complete substitute for traders. Trading bots should, therefore, be viewed as part of a strategy that complements a trader’s skills, insight, and gut feeling.

In 2019, The Economist was flagging that Gordon Gekko was becoming extinct, replaced in the trading niche by computers calling the financial shots.

With the markets continually evolving, it’s no surprise that the financial markets would embrace digitization. And not just for the back-office operations, but increasingly for monitoring the market and trading.

However, it’s not just institutions and funds that are leveraging trading bots. Individual traders are too. Indeed, trading bots got their first foothold in forex trading as far back as the early 2000s.

According to Techradar, however, the notion to automate trading can be traced back as far as the 1950s to American futures trader Richard Donchian. He pioneered the concept of using a rules-based method of buying and selling funds.

Fast-forward to today, and trading bots are mainstream, widely embraced, and enthusiastically supported by crypto-currency traders. It is estimated that bots now conduct up to 80% of all stock trades.

Though trading bots of one species or another have infiltrated every market, they are particularly popular with crypto-currency traders.

As noted by Investopedia, the main reason behind this is the incredible volatility of crypto-currencies. With prices radically changing often within just a few minutes and the 24/7 nature of the crypto markets, mere humans are at a significant disadvantage.

So why should you use a trading bot:

  • They’re fast and make trading streamlined
  • They can take care of the more mundane, time-consuming tasks
  • You can have eyes on the markets 24/7
  • Automates trading, so you don’t miss any opportunity

However, as Nischal Shetty, CEO of WazirX, notes in, not everything is rose-tinted with trading bots; there are downsides as well.

Trading bots are not infallible in highly volatile and unpredictable markets. Like human traders, trading bots have difficulty dealing with out-of-left-field developments such as the current global COVID-19 pandemic. Events like these are notoriously difficult to predict and gauge how they will affect the economy and how long.

Trading bots are, therefore, no get-rich-quick scheme or a replacement for hard-earned experience. Bots have to be programmed, so traders need to have the requisite knowledge when inputting the conditions under which it operates.

Always bear in mind that trading bots are merely a means to improve your returns marginally. You still need to do the homework and have the necessary market knowledge to make them a success.

With all of this in mind, a interview with Mihir Sukthankar, founder of Traders Circle X (TCX), highlighted that trading bots are today an integral part of building online communities of like-minded traders. Think eToro etc., platforms that have been founded on trading bots to democratize the financial markets and make trading the financial markets accessible to everyone with ten dollars to invest.

TCX, for example, has grown organically thanks to its information platform. It now has in the works BoostedQuant, a machine learning Artificial Intelligence bot that creates algorithms. Users will be able to fine-tune their BoostedQuant bot to fit their trading needs and preferences.

According to Sukthankar, building an online community involves financial journalism, education, analysis, and trading bots.

Though cold and unemotional, these bots are going to be around for a long time. And will only get better as time goes on.

Images Courtesy of DepositPhotos