How does high-frequency trading work on decentralized exchanges?

Following the growth of decentralized finance (DeFi) in 2020, decentralized exchanges (DEXs) have solidified their position in both the cryptocurrency and finance ecosystems. DEXs are not as tightly controlled as centralized exchanges, so users can list any token they want.

With DEXs, high-frequency traders can make transactions on coins before they hit the main exchanges. Additionally, decentralized exchanges are non-custodial, which means that creators cannot pull off an exit scam – in theory.

Thus, high-frequency trading firms that have specialized trades with cryptocurrency exchange operators have used decentralized exchanges to conduct trades.

What is high-frequency trading in crypto?

High-frequency trading (HFT) is a trading method that uses complex algorithms to analyze large amounts of data and make quick trades. As such, HFT can analyze multiple markets and execute large volumes of orders within seconds. In the field of business, quick execution is often the key to profit.

HFT eliminates small bid-ask spreads by making high-volume trades faster. It also allows market participants to take advantage of price changes before they are fully reflected in the order book. As a result, HFT can bring profits even in volatile or illegal markets.

HFT first emerged in traditional financial markets but has entered the cryptocurrency space due to improvements in crypto exchange infrastructure. In the cryptocurrency world, HFT can be used to trade on DEXs. It is being 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 (CEXs), such as improved security and privacy. Likewise, the emergence of HFT strategies in crypto is a natural development.

The popularity of HFTs has also led critics to condemn HFTs, as some hedge funds focused on crypto trading employ algorithmic trading to make huge profits, giving large firms a bigger foothold in crypto trading.

In any case, it seems that HFT is here to stay in the world of cryptocurrency trading. With the right infrastructure in place, HFT can capitalize on favorable market conditions in volatile markets.

How does high-frequency trading work on decentralized exchanges?

The basic principle behind 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 used for profit. For example, an algorithm identifies a certain price trend and then executes a large number of buy or sell orders to take advantage.

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

  • Using high speed and complex programs to create and execute orders

  • Minimize potential delays and delays in data flow by using colocation services provided by exchanges and other services.

  • Using short-term frames to open and close positions

  • Submitting multiple orders and canceling shortly after entering

  • Reduce exposure to overnight risk by holding short-term positions

In short, HFT uses sophisticated algorithms to analyze all cryptocurrencies at high speed on multiple exchanges. The speed at which HFT algorithms work gives them a huge advantage over human traders. They can also trade on multiple exchanges simultaneously and across multiple asset classes, making them very versatile.

HFT algorithms are developed to identify trading triggers and trends that are not easily visible to the naked eye, especially at the speed required to open multiple positions at the same time. Ultimately, the goal with HFT is to be first in line when new trends are identified by algorithms.

After a large investor opens a long or short position on a cryptocurrency, for example, the price often moves. The HFT algorithm trades these subsequent price movements in the opposite direction, making quick profits.

That said, large cryptocurrency sales are often detrimental to the market as they drag down prices. But when the cryptocurrency returns to normal, the algorithms “buy the dip” and exit the positions, which allows the HFT company or trader to profit from the price movement.

HFT in cryptocurrency is 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, can offer much faster transaction speeds. This is ideal for HFT because it requires a two second decision making and execution. In general, high frequency traders make several trades per second to accumulate modest profits over time and make large profits.

What are the main HFT strategies?

While there are too many types of HFT strategies to list, some have been around for some time and are not new to experienced investors. The idea of ​​HFT is often associated with conventional trading techniques, which use excellent IT skills. However, the term HFT can refer to more fundamental ways of exploiting opportunities in the market.

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

In short, HFT can be considered a strategy in itself. As a result, rather than focusing on HFT in general, it is important to analyze specific trading methods 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 can buy it on the first exchange and then immediately sell it on the second exchange for a quick profit.

An example of a crypto arbitrage strategy

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

HFT greatly benefits arbitrageurs because the window of opportunity to execute arbitrage strategies is usually very small (less than a second). To quickly take advantage of short-term market opportunities, HFTs rely on powerful computer systems that can quickly scan markets. In addition, HFT platforms provide arbitrage opportunities and can execute trades up to 100 times faster than a single trader.

Market making

Another common HFT strategy is market making. This involves simultaneously placing buy and sell orders for the security and profiting from the bid-ask spread – the difference between the price you’re willing to pay for an asset (ask price) and the price you’re willing to sell it for (bid price).

Large companies called market makers provide liquidity and good system in the market and are popular for regular trading. Market makers can connect with cryptocurrency exchanges to ensure market quality. On the other hand, there are also market makers who have no agreement with the exchange platforms—their goal is to use their algorithm and profit from the distribution.

How a marketing strategy works

Market makers regularly buy and sell cryptocurrencies and set their bids, earning a small profit on each trade. For example, they might buy Bitcoin from someone who wants to sell their property for $37,100 (the ask price) and offer to sell it for $37,102 (the bid price).

The $2.00 difference between the bid and ask price is called the spread and is essentially how market makers make money. And, while the difference between the ask and bid price may seem insignificant, trading heavily during the day can yield huge profits.

The spread ensures that the market maker is compensated for the inherent risk associated with such transactions. Market makers offer instant rates to the market and enable buyers and sellers to trade at the right price.

Short term opportunities

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

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

Voice marketing

Another common HFT strategy is volume trading. This involves keeping track of the number of shares traded in a given period of time and making trades accordingly. The logic behind this is that as the number of trading stocks increases, the volatility of the market increases, making it easier to buy or sell more stocks without over-moving the market.

Related: On-Chain Size vs. Business Size: Differences Explained

Simply put, volume trading means taking advantage of the market’s liquidity.

High-frequency trading allows traders to execute many trades quickly and profit from even small market fluctuations.

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