Trading bots: guarantee of profit or imminent risk?

July 3, 2020   Bitcoin

We all understand that in trading one side wins, the other side loses. Then we change places: this is the law of the market. In other words, each trader, without exception, at some point suffers losses. To minimize losses and increase profit, people started using trading robots, which are often positioned as fast, automated, round-the-clock, flawless tools. It sounds perfect, but is it really so?

In this article, we will try to overview trading bots for automating cryptocurrencies trading and optimizing risk management, which can help achieve excellent trading results.

Cryptocurrency trading bots can make profit, but, unfortunately, as with any trading strategy, their effective functioning period is quite short. Trading bots die and make mistakes - like humans. Therefore, one day a trading bot you selected may become ineffective, even if it has demonstrated great results during a long period of time. You should always remember: previous trading bot results cannot guarantee profitable trading in the future. Why is it so?

First of all, a trader has to understand one obvious fact. The financial market is constantly changing, and more and more traders see the inefficiency of the market in which you are currently earning, they see certain dynamics. The more people use a pattern that can be used to earn money, the less profitable it becomes. That is why any strategy or bot will lose effectiveness after a while. In the case of trading bots, this starts with a long-term “zero” profit, which smoothly leads to losses usually in about 80% of cases. The other 20% of cryptocurrency trading bots may surprise you with a sudden drawdown in the deposit, which exceeds all the limits you set. In general, the profitability of trading bots is limited by a frightening range of risks, which vary depending on the type of trading bot. Let's consider what risks are inherent in different types of trading bots.

Arbitrage trading bots


These bots simultaneously trade an unlimited number of contracts or altcoins on several cryptocurrency exchanges. As a rule, the profitability of such a bot is 20-50%. Are you impressed? And so are we. But remember the risks!

Technical risk


The main one is technical risk. One of the cryptocurrency exchanges on which the bot operates may unexpectedly suspend trading, blocking arbitrage possibilities or stopping your profitable transaction. Result: you take unlimited risk, because instead of a neutral (hedged) position, you are simply a buyer or seller. Also, in arbitration, leverage is often used, which increases your risk at times. Thus, your profitability largely depends on the quality of maintenance and all kinds of errors that occur on the network.

Scalping bots / HFT bots


HFT bots (high-frequency trading) make a huge number of transactions with minimal profitability, constantly increasing your deposit. And there is two news - good and bad. Let's start with the good one!

  • Good: over 80% of scalping deals are profitable, which makes the technical risk less dangerous for this kind of trading bots. They will quickly compensate for possible losses, making them not so painful for a trader’s deposit.
  • Bad: there are several more significant risks for this kind of bots:

Inappropriate trading lot size


First of all, a scalping bot is a powerful piece of software, but only if a trader knows how to properly use it. At times, traders driven by avarice increase their positions, eventually making them too large for the bot. As a result, the bot becomes absolutely ineffective. Unfortunately, this is one of the most common mistakes made by many novice crypto traders.

Faster rivals


In addition, since scalping is a high-speed race of cryptocurrency traders, your bot is rather vulnerable to faster competitors, which, for example, use the best access channel/ connection to the exchange. Once you are overtaken, any ingenious strategy loses effectiveness due to the competitor’s higher speed. And, alas, you lose again.

Pair trading, investment bots and indicator bots


All these bots work, relying on various models confirmed by time and historical market data.

Pair trading, or mirror trading, is trading in assets that have a high correlation coefficient, direct or reverse, so the price movement of one asset can be predicted based on the price dynamics of another asset. For example, in the cryptocurrency market, there is a strong dependence of many assets on the price of Bitcoin - the correlation table shows high values. So, based on such dependencies, you can open opposing positions on related assets, thus hedging risks. Or, for example, if one asset deviates from the usual trajectory, when it begins to live its own life, we can assume that the relationship will soon be restored, and make a trading decision based on this assumption.

Investment bots create a profitable portfolio to ensure constant passive income. Bots select several crypto assets for investment, based on their historical effectiveness and the ability to collectively hedge risks. So, they can make up a portfolio of high and low risk assets and change their ratio depending on market dynamics.

Bots that work on the basis of indicators also use historical patterns - price and volume movements, and make transactions based on signals coming from indicators.

Let’s overview the risks for these types of bots.


Irrational market behavior

The key danger in this case is “past”. All of these bots use historical price dynamics as the basis for decision making. Yes, many lessons can be learned from history, but remember that time is not your best and only adviser. As soon as the dynamics of asset prices becomes different, the time-proved correlation disappears, as do patterns, signals and so on. In this case, the trader still hopes to get the expected profitability, but suffers losses instead, which is a frequent psychological trap in trading. In general, changes in price dynamics often occur at peaks: they are the common sign of upcoming changes in the state of the market.

The same thing happens with indicators that become useless even with a slight change in the assets’ behavior. The logic of patterns is easily broken, making the bot useless. As you may guess, frequent changes are typical for the cryptocurrency world, where high volatility is the norm. For example, on March 13, 2020, Bitcoin lost half its value, depriving even professional traders’ deposits. So how can we count on investing bots in the long term perspective? The cryptocurrency market is changing at breakneck speed, bringing Black Swans, giving birth or killing crypto assets in a matter of hours. Therefore, such bots are rather short-lived.

Trend bots

Obviously, these are bots that work with trends in the market. We are talking about long-term trading, about analyzing market cycles. An example of 4 stages of a cycle in the cryptocurrency market is given below:

Market cycles on the example of Bitcoin dynamics

Trend bots are designed for catching large market movements at the very beginning of their formation, that is, determining a transaction entry point at the most proper time. If this happened, it’s great! You can expect a significant influx of profit to your deposit: if you caught the second stage of the market in 2017, the bot would bring you approximately 300% profitability -growth from $5k to $20k! However, here we are faced with another problem: what to do if there is no trend at the market at all?


Unfavourable market conditions

  • Firstly, in the absence of a trend, we can linger in a long-term drawdown, because the trading bot is simply not suitable for making money sideways. Thus, you will suffer losses until a market trend sets in. And can you sustain this period and not leave the game? At the same time, you should keep in mind that you do not know exactly when the trend will begin, which is a psychological stress. The only way out is to obediently wait and hope to at least survive in this market. But there is one “but”: “The market may remain irrational longer than you will be solvent.” (c) John Maynard Keynes. Then ask yourself, are you ready to be in a drawdown, for example, during six months?
  • Secondly, being in the long-term sideways, you can miss the moment when the state of the market has changed so much that the bot algorithms no longer work. Again, you will never know if you have a “normal” drawdown or perhaps something went wrong with a bot that will miss the entry point, as the market conditions have changed too much.

And these are just few examples of the possible risks of trading bots. Traders do not even pay attention to other risks, such as, for example. a small error in the code that instantly destroys any strategy, turning trade literally into the distribution of your money, you must admit that it’s ridiculous and sad.

Conclusion


So, are trading bots a guarantee of high profits or huge risks? It turns out that they are both, and what you get in the end depends on you. As you can see, each bot has its own set of advantages and risks, but bots alone are unlikely to make you a millionaire. Therefore, their effectiveness can be equated to a 20% contribution to your long-term profitability. The remaining 80% of success is your comprehensive risk and money management, constant monitoring and improvement of bot algorithms! Yes, this is about calculations, collection of trade statistics, detailed planning of trade. We advise you to read about how hedge funds organize their work - they cannot afford losses!

Author: Kate Solano for Сrypto-Rating.com
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