What is crypto spot trading?
The spot market is an exchange where retail traders make purchases intending to swap their fiat currencies or other digital assets for other assets with immediate delivery. In many cases, you can quickly withdraw these assets to a crypto wallet instead of keeping them on the exchange. The spot market is the place where assets are traded directly.
The most common exchange medium for spot trading in crypto is a stablecoin. Depending on the exchange, you may be working with Tether (USDT), Binance USD (BUSD), or USDC (USD Coin). While the spot market may feature other types of pairings, there is usually enough liquidity only for the most popular digital assets paired with stablecoins.
Again, the main intention of a trader on the spot market is to obtain digital assets or swap them. These assets are denominated in corresponding units and are stored in the account balance until withdrawn or traded again.
What is crypto pairs trading?
This type of transaction on a centralized exchange has a different underlying mechanic. Pairs are direct comparisons between two different types of assets without an exchange medium. Since the market may be too slow to react to price changes in certain pairs, many opportunities for triangular arbitrage present themselves naturally.
An assumption made by retail traders who engage in pairs trading is that they can correctly evaluate the relative values of two digital assets. A valid crypto pairs trading strategy usually involves a sequence of operations on behalf of both trading parties:
- The evaluation of the comparison between two digital assets;
- Comparing both assets to a single exchange medium (usually a stablecoin pegged by the US dollar);
- Comparing prices denominated in stablecoins;
- Finalizing the deal if conditions seem favorable.
The most common method of using automation for pairs trading is automated triangular arbitrage. It is more complex than dealing with asset pairs on different exchanges, but it is way less intimidating than statistical arbitrage.
An example of triangular arbitrage
Imagine a scenario when you monitor three pairs: BTC/ETH, ETH/USDT, and BTC/USDT. Let’s say that the current pricing is as follows:
- BTC/ETH is priced at 5 units.
- ETH/USDT is priced at $2,100.
- BTC/USDT is priced at $10,000.
At first glance, there are no interesting developers. However, if you simultaneously buy 5 ETH for 1 BTC and sell ETH at $2,100, you will make $500 in profit without ever experiencing negative cash flow. It will be like you just magically received $500.
Such situations occur rarely. All forms of arbitrage are, theoretically, risk-free when perfect conditions align. The only issue is that such conditions occur infrequently and do not have such dramatic discrepancies. Nonetheless, it is a valid strategy to use if you can run a multitude of bots simultaneously.
This situation is quite simple because we see relationships between assets and can use a shared medium for comparison purposes.
The key difference between pairs and spot trading
Spot trading uses the order book to organize the market. All retail traders can look at this book and see “bids” (buy orders) and “asks” (sell orders). The amounts of different orders usually demonstrate the “depth” of the market for any given asset. The goal of a trader is to acquire assets at the lowest possible price and hold them until a good opportunity to sell presents itself.
Pairs trading is creating two positions: one will be a long position for one asset and another a short position for a correlated asset. The goal of a trader is to identify the price discrepancy by using a variety of analytical techniques and make money by identifying correlations between prices.
Another approach that is often used by people engaging in day trading crypto pairs is looking for cointegration between two different assets. Cointegration is a relationship between price action which can be indicative of other indirect connections between some assets. This information can be used for statistical and triangular arbitrage when the exchange medium is not as straightforward as USDT or BUSD.
For example, two different assets can be compared to a third asset that does not have any direct correlation with the first two. Let’s say, you are looking at pairs: BTC/ETH, ETH/DOGE, and BTC/DOGE. The relationship can be obscure and hard to notice. Only after careful evaluation, one can make a sound financial decision.
Running pairs trading software
All crypto pairs trading strategies require the deployment of custom-made bots that follow strict rules carefully laid out by users. Since both statistical and triangular arbitrage requires a complex signaling system that may need writing a sophisticated script in Pine Editor at TradingView, many retail traders stay away from using automation.
The system will look quite complicated:
- You need to upgrade your TradingView plan to monitor three price charts simultaneously.
- The signals must overlap and allow for the creation of the overall script that commands bot that it must act.
- There must be at least two bots. One will be entering a long market position, another one — short.
- Orders must be placed instantly and simultaneously to guarantee profitability.
Unlike other bots like preset solutions that work on the spot market (DCA or GRID), such systems require a long process of designing, testing, and deploying which can be quite challenging for people without any background in financial markets and coding.
WunderTrading has special solutions that can be easily edited and turned into a good bot for day trading crypto pairs. Preset arbitrage systems can be remade into pairs trading bots with relative ease. However, you will still need to use cointegration and correlation analysis to make sure that selected assets are still indirectly related.
Running a crypto spot trading bot
Since all operations in the spot market are straightforward, you can use a plethora of preset solutions and relatively simple automated trading systems to make money. Let’s discuss some of the bots that you can deploy on a spot market.
- Distributed Cost Average (DCA). These bots are buying assets during a downtrend in multiple orders separated by set periods in an attempt to reduce the average price of assets. These purchases can be accompanied by a single “take profit” and/or “stop loss” order if you are interested in making money immediately. Alternatively, the bots can be used to simply buy digital assets for long-term market positions.
- GRID. This word is not an abbreviation. The name comes from a distinct pattern that appears on the price chart in the terminal when the bot has several open market positions that were not yet liquidated. The bot uses the same logic as DCA but adds individual “take profit” and “stop loss” orders to each created market position. Lines form a grid that gives the name to this bot type.
- Geographical arbitrage. Spot markets may have significant price discrepancies between exchanges separated by miles. For example, the price of BTC against USDT can be $20,000 on Binance US and $20,010 on ByBit. You can make a profit by buying on Binance and selling on ByBit simultaneously. Bots monitor several spot markets to find such opportunities.
A rich variety of technical analysis strategies are designed to work with straightforward financial instruments. It means that you can use virtually any technical analysis strategy and adjust it to work with any asset showcased on the spot market. Opening long and short positions simultaneously is also not necessary which is important since opening multiple positions at once may stress your portfolio.
Risk management in sport and pairs trading
When it comes to the spot market, managing risks is quite easy and straightforward. You can reduce your exposure to risks by correcting “take profits” and “stop losses”. You may also choose specific assets that are less volatile to ensure that you have some control over your market positions and can react to price action in a timely manner.
Managing risks in pairs trading is way more difficult. Several factors complicate risk management:
- You need to have sufficient capital to open and hold two market positions simultaneously.
- The market can “squeeze” you. It happens when both positions go into negative.
- The statistical correlation or cointegration may disappear suddenly without any signals.
- The initial assumption about the correlation between pairs can be wrong.
All these problems are hard to predict. The analysis requires dedication, effort, and skill while often producing incorrect assumptions that are used to base a whole strategy involving relatively big capital investments.
You can indeed mitigate risks and both market positions could turn out to be profitable, but you must be well-informed about the market situation, have strong analytical and mathematical skills, and feel confident about every single market position.
Should you use pairs trading?
As mentioned above, you need a certain set of skills to use pairs trading methods correctly. At the same time, it is quite hard to automate. Bots give retail traders a significant advantage over human traders which means that investors who do not use automation lag behind their competitors who do. You should look at strategies that can be easily improved by automation.
Pairs trading requires you to approach the analytical process from multiple angles:
- Use fundamental analysis to evaluate several digital assets and their “fair” prices.
- Employ statistical analysis to look for correlations or cointegrations.
- Use technical analysis to analyze price action and trading volumes.
- Overlap results of all types of analysis and try to find a relationship.
Often, this whole process is futile because analyzed assets never had a relationship or do not have it right now. It means that you need to start over. Even with experience, it takes time to find a good pair to work with.
If you are willing to invest so much time, effort, and concentration in a strategy with the only good upside being moderate risk mitigation, you can do it. However, an average retail trader will probably find the process too intense and demanding.
How to automate spot or pairs trading
Whether you want to focus on one or another, the process of integrating automation into your investment practices will be the same:
- Create a new account at WunderTrading if you still do not have one.
- Create a new account at TradingView if you plan to automate a technical analysis strategy.
- Connect a spot market or margin account on your exchange to WunderTrading.
- Create a new bot using the dashboard and launch it. Watch detailed tutorials to learn how.
- The automated trading system will work without additional inputs.
Note that the profitability, risk level, and other metrics depend on your preferences, bot settings, and chosen strategy. It is possible to automate any type of technical analysis strategy, but you should not expect that bots will magically start printing money without detailed initial input from their users.
The main takeaway
Spot trading is a straightforward swapping of digital assets for other assets and currencies. Pairs trading is a specific approach to trading where retail traders try to mitigate risks and evaluate digital assets that may not be directly connected or comparable. Both strategies can be automated with the help of WunderTrading. You can use this automation platform to create sophisticated automated trading systems!