How does high frequency trading work on decentralized exchanges?

Following the decentralized finance (DeFi) boom of 2020, decentralized exchanges (DEXs) cemented their place in the cryptocurrency and finance ecosystems. Since DEXs are not as heavily regulated as centralized exchanges, users can list any token they want.

With DEXs, high-frequency traders can transact coins before they reach major exchanges. Additionally, decentralized exchanges are non-custodial, implying that creators cannot pull an exit cheat – in theory.

As such, high-frequency trading firms that negotiated one-time trade transactions with cryptocurrency exchange operators turned to decentralized exchanges to conduct their business.

What is High Frequency Crypto Trading?

High Frequency Trading (HFT) is a trading method that uses complex algorithms to analyze large amounts of data and make fast trades. As such, HFT can analyze multiple markets and execute a large volume of orders within seconds. In trading, fast execution is often the key to making a profit.

HFT eliminates small bid-ask spreads by performing large trading volumes quickly. It also allows market participants to take advantage of price changes before they are fully reflected in the order book. Therefore, HFT can generate profits even in volatile or illiquid markets.

HFT first appeared in traditional financial markets, but has since made its way into the cryptocurrency space thanks to infrastructural improvements in crypto exchanges. In the world of cryptocurrency, HFT can be used to trade on DEXs. It is already used by several high-frequency trading houses such as Jump Trading, DRW, DV Trading and Hehmeyer, the Financial Times reported.

Decentralized exchanges are becoming increasingly popular. They offer many advantages over traditional centralized exchanges (CEX), such as improved security and privacy. As such, the emergence of HFT strategies in crypto is a natural development.

The popularity of HFTs has also led some hedge funds focused on crypto trading to use algorithmic trading to produce large returns, prompting critics to condemn HFTs for giving large organizations an edge in crypto trading. .

Either way, HFT seems to be here to stay in the cryptocurrency trading world. With the right infrastructure in place, HFT can be used to generate profits by taking advantage of favorable market conditions in a volatile market.

How does high frequency trading work on decentralized exchanges?

The basic principle of HFT is simple: buy low, sell high. To do this, HFT algorithms analyze large amounts of data to identify patterns and trends that can be exploited for profit. For example, an algorithm can identify a particular price trend and then execute a large number of buy or sell orders in rapid succession to take advantage of it.

The United States Securities and Exchange Commission does not use a specific definition of high frequency trading. However, he lists five main aspects of HFT:

  • Use fast and complex programs to generate and execute commands

  • Reduce potential delays and latencies in data flow by using colocation services offered by exchanges and other services

  • Use short timeframes to open and close positions

  • Submitting multiple orders and then canceling them shortly after submission

  • Reduce day-to-day risk exposure by holding positions for very short periods of time

In a nutshell, HFT uses sophisticated algorithms to continuously scan all cryptocurrencies across multiple exchanges at super high speeds. The speed at which HFT algorithms operate gives them a significant advantage over human traders. They can also trade on several exchanges simultaneously and on different asset classes, which makes them very versatile.

HFT algorithms are designed to detect trading triggers and trends that are difficult to observe with the naked eye, especially at the speeds required to open a large number of positions simultaneously. Ultimately, the goal with HFT is to be first in line when new trends are identified by the algorithm.

After a large investor opens a long or short position in a cryptocurrency, for example, the price usually moves. HFT algorithms exploit these subsequent price movements by trading in the opposite direction, quickly making a profit.

That said, large cryptocurrency selloffs are generally detrimental to the market as they usually drive prices down. However, when the cryptocurrency returns to normal, the algorithms “buy the dip” and exit the positions, allowing the HFT firm or the trader to take advantage of the price movement.

HFT in cryptocurrency is made possible because most digital assets are traded on decentralized exchanges. These exchanges do not have the same centralized infrastructure as traditional exchanges, and as a result, they can offer much faster trading speeds. This is ideal for HFT, as it requires split-second decision making and execution. Typically, high frequency traders execute many trades every second to accumulate modest profits over time and generate a large profit.

What are the best HFT strategies?

Although there are too many types of HFT strategies to list, some of them have been around for a while and are not new to experienced investors. The idea of ​​HFT is often tied to conventional trading techniques that take advantage of advanced computing capabilities. However, the term HFT can also refer to more fundamental ways of taking advantage of market opportunities.

Related: Crypto Trading Basics: A Beginner’s Guide to Cryptocurrency Order Types

In short, HFT can be considered a strategy in itself. Therefore, instead of focusing on HFT as a whole, it is important to analyze particular trading techniques that use HFT technologies.

Crypto Arbitrage

Crypto arbitrage is the process of making a profit by taking advantage of price differences for the same cryptocurrency on different exchanges. For example, if a Bitcoin (BTC) costs $30,050 on exchange A and $30,100 on exchange B, one could buy it on the first exchange and then immediately sell it on the second exchange for a quick profit.

Crypto traders who take advantage of these market inconsistencies are called arbitrageurs. By using efficient HFT algorithms, they can take advantage of spreads before anyone else. In doing so, they help stabilize markets by balancing prices.

HFT is very advantageous for arbitrageurs because the window of opportunity to conduct arbitrage strategies is usually very small (less than a second). To quickly seize short-term market opportunities, HFTs rely on robust IT systems that can quickly scan the markets. Moreover, HFT platforms not only uncover arbitrage opportunities, but can also complete trades up to hundreds of times faster than a human trader.

To the market

Another common HFT strategy is market making. This involves placing buy and sell orders for a security at the same time and taking advantage of the bid-ask spread – the difference between the price you are willing to pay for an asset (ask price) and the price at which you are ready to sell it (offer price).

Large companies called market makers provide liquidity and good order in a market and are well known in conventional trading. Market makers may also be tied to a cryptocurrency exchange to ensure market quality. On the other hand, there are also market makers who do not have an agreement with the exchanges, their aim being to use their algorithms and profit from the spread.

How the Market Making Strategy Works

Market makers constantly buy and sell cryptocurrencies and set their bid-ask spreads so that they make a small profit on each trade. They can, for example, buy Bitcoin at $37,100 (the ask price) from someone who wants to sell their Bitcoin holdings and offer to sell it at $37,102 (the bid price).

The $2.00 difference between the bid and ask prices is called the spread, and it is primarily how market makers make money. And, although the difference between the ask price and the bid price may seem insignificant, day trading in volumes can generate a significant portion of profit.

The spread ensures that the market maker is compensated for the legacy risk that accompanies these trades. Market makers provide liquidity to the market and make it easier for buyers and sellers to trade at fair prices.

Short term opportunities

High frequency trading is not for swing traders and buy-and-holders. Instead, it is used by speculators who want to bet on short-term price fluctuations. As such, high frequency traders move so quickly that price may not have time to adjust before acting again.

For example, when a whale dumps a cryptocurrency, its price typically drops for a short time before the market adjusts to meet the balance between supply and demand. Most manual traders will lose this dip as it will only last a few minutes (or even seconds), but high frequency traders can take advantage of it. They have time to let their algorithms work, knowing that the market will eventually stabilize.

Volume Trading

Another common HFT strategy is volume trading. This involves tracking the number of shares traded over a period of time and then making trades accordingly. The underlying logic is that as the number of stocks traded increases, market liquidity also increases, making it easier to buy or sell a large number of stocks without moving the market too much.

Related: On-Chain Volume vs. Trade Volume: Differences Explained

Simply put, volume trading is all about taking advantage of market liquidity.

High frequency trading allows traders to quickly execute a large number of trades and take advantage of the smallest market fluctuations.

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