Virtual robots, or bots, are deployed for an increasing number of uses in society today. Aside from being used to help optimize and speed up customer service operations, investor Daniel Calugar says traders are using bots to simplify, streamline and automate the trading process.
Trading bots are software programs that execute financial trades automatically. So instead of human traders sitting in front of their computer or mobile device all day long just waiting for the perfect time to complete a trade, they employ trading bots to do all this work for them.
Trading bots are often part of what's called algorithmic trading or high-frequency trading. The bots are powered by computer coding that tells them when to act and how to act, and they can execute a large number of trades in a short period of time.
This type of trading is quickly becoming commonplace in the industry, with most estimates saying as much as 50% of all trades in the equity markets are being done via trading bots.
Below, Dan Calugar will describe in more detail what trading bots are, whether they are advantageous, and some potential pitfalls of using them.
The Problem Trading Bots Solve
Trading bots were created to solve a prevalent problem for professional traders -- to help make trading financial assets more efficient and effective. Bots are yet another tool that traders can use to help them become more profitable on a more consistent basis, wading through the wealth of data and information about the market and taking advantage of all the prime opportunities before it's too late.
Today, traders have many tools that allow them to gather data about the market and analyze it relatively quickly. Most of these tools are software that provides the trader with information, even helping by notifying them when certain market conditions present themselves so they know when to make a trade.
While all of these tools certainly make trading more accessible and more effective than it was even 20 years ago, there are still some significant challenges to overcome, according to Daniel Calugar.
For one, there's so much information and data available today that wading through it all can be quite complicated and confusing and take a lot of time -- even when proper signals and notifications are set up.
In addition, these tools only provide the trader with information. To capitalize on this information, they still must manually execute a trade based on the provided data.
This can cause a delay between when the actual prime opportunity presents itself and when the trader can execute the trade. As any experienced trader knows, timing is everything in the market. A trade completed even a minute or two late can present significantly different outcomes.
Trading bots help to solve all of this. They are another layer added on top of the software to take the information, quickly analyze it, and automatically execute trades based on specific parameters.
What Trading Bots Can Do
As virtual programs, trading bots can do whatever they are told to do. As a result, they are highly customizable, which is why there are so many different versions of trading bots on the market.
In layperson's terms, all trading bots analyze a large amount of data and information in mere milliseconds and then take some action once that analysis is complete. How they interpret the information, what trading principles and strategies they base the analysis on, and what actions they take are all customized and personalized by the individual trader or firm.
Traders can set specific parameters for when the bot will take action, which could include taking action any time a particular asset's price moves a certain percentage below its average price over the last six months, for instance. But, again, there is no limit to what the investor can ask the bot to do.
Much of this work will be done in the background and constantly, while traders themselves can focus on doing other work. As a result, they don't have to spend hours doing manual real-time market analysis, trying to keep everything straight.
There are algorithms that are coded for traders that will put this analysis into motion, Dan Calugar explains. The trading bots then sit "on top of" the algorithm, replacing the human in the next step of the process.
Typically, a trading bot will do one of two things. It will either notify the trader that a particular criterion has been met through trading signals, or they will automatically execute a buy/sell trade.
Why Automation is Preferred
The simplest form of a trading bot is the one mentioned above, which sends trading signals to the investor once certain market conditions are met. While this is undoubtedly helpful, it's not using bots to their fullest potential. Many trading software packages have these buy/sell signals built into the program.
The true power of trading bots is the ability to automate the trading process. While real-time trading signals are certainly nice, they still require the human trader to physically process the trade, which can take a lot of time.
By contrast, a trading bot can execute multiple trades simultaneously or at the exact moment that a certain criterion has been met. This removes the time lag that can occur when the trade signal is sent, and the human can process the transaction, which enables traders to time the market perfectly. There's no longer a concern, then, that you may have gotten a worse price by the time you were able to execute the trade.
Trading bots can be connected to trading exchanges to automatically execute the trades on behalf of the investor. They simply set the parameters for what constitutes a trading opportunity -- just as they would for the signals -- and then tell the bot exactly what to do when the situation arises.
Taking the example from above, this could mean that if a particular asset's price drops 15% below its average price for the last six months, the trading bot could automatically purchase 5,000 shares of that stock as soon as it met that 15% threshold.
The bot wouldn't require any action from the human trader, simply executing the trade automatically and notifying the human that it had been done.
The beauty of trading bots, Daniel Calugar says, is they can be set up to act on any number of different market trends. As the algorithm tracks events such as trading volume, overall demand, selling or buying pressure, price movement, and various technical indicators, the trading bot can be programmed to execute defined trades when the pre-determined conditions are met.
Rather than using the information the algorithm provides and making a trade after the fact -- as humans do when they execute trades manually -- trading bots execute trades at the exact moment the market changes happen.
What Types of Trading Bots Are There?
While bots can be used to help power just about any type of trading strategy, there are some general ways that trading bots are put into practice. Dan Calugar will describe some of these types of trading bots below.
This is the basic example provided above, and it's one of the most common ways trading bots are used. Trading based on comparing current asset prices to their average price over a period of time is a fairly basic strategy.
The challenge to the strategy is that it requires impeccable timing. Miss a price by even a few minutes, and you may have missed the opportunity altogether. This is where trading bots can be extremely helpful.
Once they've determined that the current price of an asset has fallen below or above a certain level compared to the average price of that asset over a defined period, the trading bot can automatically execute the exact trade you tell it to. This could be to buy or sell 250 shares, for example, based on whether the current price has risen above or below the average.
A strategy built around moving averages is considered to be "trend trading," and there are many different market trends that you track and set up your trading bot to execute.
Trading bots can really excel in arbitrage trading. This is because arbitrage can be quite complicated, as it requires you to follow and analyze not only current market activity and the different markets out there.
Arbitrage trading seeks to take advantage of price differentials from one market to the next, simultaneously selling the asset in one market while buying it in another. This may seem counterintuitive but capitalizing on market inefficiencies can be very effective.
In the traditional investing market, these opportunities are often seen in stocks compared to futures. The current price of a stock may not align with futures instruments, which provides an excellent opportunity for savvy investors.
As mentioned before, the challenge is identifying these opportunities since it requires so much technical analysis and analysis of the different markets. Trading bots can be programmed to do this for you and automatically execute both ends of the trade at the same time.
This latter part is crucially important in arbitrage. Both ends of the arbitrage -- the buy and the sell -- need to be executed as closely as possible to optimize the price discrepancy in your favor. That can be hard for humans to do, but it's a straightforward task for trading bots.
TWAP, or Time Weighted Average Price, is another perfect example of how impactful a trading bot can be. The TWAP strategy involves breaking up larger orders into smaller slices of that order in a dynamically determined way.
The smaller portions of the overall order will be executed in specified time slots regularly over a certain period. Daniel Calugar provides a very simplified example of a TWAP strategy:
The total order could be to purchase 12,000 shares of an asset. TWAP would have this broken down into six smaller orders of 2,000 shares spread out over one hour. So, for this example, the TWAP strategy would execute a purchase of 2,000 shares every 10 minutes.
The goal of the TWAP strategy is to execute the overall order as close to the asset's average price for the duration of the set period. It ultimately minimizes the market impact of the trade instead of executing the trade all at once.
The trading strategy can be very effective, but it can also be challenging to execute perfectly, requiring a lot of manual work. In the example above, the trader would need to execute the same trade every 10 minutes. That could be impossible for them to do, depending on the trade and the steps it takes.
This is where a trading bot can come in handy. The bot can easily execute all of those trades at pre-defined periods of time, and it will do it at the exact moment you want it to. There will be no delay at all, allowing you to optimize the TWAP strategy perfectly.
Benefits of Using Trading Bots
Some of the benefits of using trading bots have been described above, but it's worth breaking them down into separate sections. After all, trading bots can be used in so many different ways by so many different types of traders that the above may not have mentioned an example of how you would use trading bots.
Timing is one of the most significant benefits of trading bots. The result of all trades is predicated on when the trade is executed. Sometimes, though, that timing can come down to a minute. For instance, a trade executed one minute late could mean a missed opportunity that could have monumental negative consequences for the overall strategy.
Trading bots can execute trades at the exact moment that favorable market conditions present themselves. There is no delay from when the market condition happens and when the human trader can manually execute the trade.
Trading bots help to simplify the investment process. They can easily take the analysis completed by an algorithm or computer program and make split-second decisions based on it. In fact, trading bots can make an infinite number of these split-second decisions simultaneously, which humans simply can't do.
This helps to make trading much easier. For example, with trading bots, human traders don't have to worry about analyzing the results of trade signals and deciding whether to execute the trade.
Trading bots can help with other mundane tasks, too, such as automatic portfolio re-balancing. If you want to ensure that your portfolio is rebalanced regularly, you'll need to constantly monitor the current state of the funds and then execute trades to re-balance it. Trading bots can do this on a pre-defined basis for you.
They can also be used to take advantage of Index Funds that re-balance as well. For example, trading bots can execute specific trades before pre-determined Index Fund re-balancing to take advantage of expected price differences.
Trading bots also help traders keep emotions out of the process. Even the most disciplined traders can have trouble keeping their emotions at bay. Trading bots have no emotions and only execute trades based on objective information, data, and analysis.
Limitations of Trading Bots
While there are many benefits of using trading bots, there are also some limitations. Daniel Calugar provides some of those below.
Trading bots will only be able to execute what you tell them to execute. While they can process an impressive amount of information at lightning speed, they cannot make deductions outside the parameters set.
In other words, if a market opportunity provides itself but the trading bot hasn't been programmed to track the information, it won't be able to execute the trade for you. Humans would be able to make this deduction, even if certain buy/sell signals aren't set up for them.
You have to be careful to set up trading bots properly, and you also have to ensure that you're constantly monitoring and tweaking the bots as market conditions change. If you don't, it's possible the trading bots could make incorrect trades before you're able to stop them.
When market conditions change, human traders can decide to hold off on typical trades they might make as they take time to analyze where the market goes. This could be especially valuable in times of significant market volatility.
Trading bots won't know to do this. So, if you don't tweak the bots to respond to these market changes -- or pause them temporarily as you figure out the situation -- the bots may make trades that you no longer want them to make. This could result in you making trades that can cost you a lot of money.
So, while trading bots can be great at optimizing your market returns, you need to tread carefully with them.