Grid Trading (PART I), an alternative source of Alpha for crypto traders and Defi protocols
Like it or not, the crypto ecosystem (and I would mainly focus here on traders and Defi protocols) is navigating a “risk asset” winter. The market cap of crypto has been hovering directionless for months, suspicion has been growing over centralized exchanges (CEX) following the collapse of FTX, while liquidity turns further to decentralized exchanges (DEX). But DEXes still suffer from lack of depth. The great idea of decentralization is still in building and we, at Deus ex DAO, are bringing our contribution to increase the attractiveness to retail and wholesale investors.
Many opportunities have been overlooked until now, which have proven successful in other traditional spaces, and in this piece we will focus on grid trading.
Strong from my 25 years experience as an institutional and retail investor in both Tradfi and Defi, I have been implementing “trading grids” in the FX space and more recently in stocks and crypto tokens.
In this article and the next one (Part II), I wish to share my experience with those techniques in the crypto space,
- how traders can use them
- how they should be considered by DEX to increase the depth of their order book. The success of DEXs will only come with its liquidity.
- how they can be replicated through options or help understand options value (Part II)
What is Grid Trading?
Grid trading is a systematic trading strategy that involves placing orders in a “price grid” of orders. The price grid consists of orders at incrementally increasing or decreasing prices. For instance, you may set buy orders at every $100 below the current market price of Ethereum (ETH), and sell orders every $100 above ETH’s current price.
The basics of this strategy is to repeatedly buy at the pre-specified price, and then sell the position when the price rises above that level. Conversely, you can sell at a predetermined price point and wait for the price to fall to a set level and buy — repeatedly.
The set of orders can be arithmetic (set at an interval of 100$) or geometric (set at an interval of 1% of the nearest order).
Grid trading is very common in the FX market and it has recently seen a strong usage within Crypto Centralized Exchanges (CEX). The exchanges market this strategy as a way to help crypto traders, who are not able to react quickly enough, to take advantage of opportunities to profit from rapid price swings in tokens which are trading around the clock, 7 days a week.
CEXs like Bybit or Kucoin have understood the appeal of these techniques and have developed fully automated grid trading bots on spot, futures and perps prices. Off-the-shelf bots such as Insilico Terminal or Cryptohopper facilitate this strategy in other exchanges as well. Users can easily automate buy and sell orders placed at predetermined intervals by customizing the grid limits (upper and lower), the number of grids and the amount they are ready to invest (the maximum amount accumulated should you trade on the lowest order for a long grid strategy, for instance). Once the set-up is complete, the system will automatically buy or sell orders at these pre-set prices.
As described in an article by Quantpedia, strategies can become slightly more complex and involve more parameters. For instance, we could be placing sell orders when the price increases to one and a half grid length from the price where we placed the buy order. We could as well be including a “trigger price”, a switch which allows trading to be turned on only when the market price of the trading currency reaches the trigger price. In this article I stick to basic trading grid strategies.
Why would Traders use a Trading Grid?
Grid trading has been battle tested in the FX market. I have mainly been using manual grid trading to enhance the return of ranging stocks recently, typically dividend stocks like REITs and other trusts which are very common on the Singapore stock exchange, with which I am rather familiar.
Since I ventured into the crypto space, and because I realized it was made easy to use them, I have been digging deeper into its purpose and concept.
Grid Trading can turn soggy strategies into profit during a quiet market. Rather than have your crypto assets stagnate along with the market, you can use grid trading strategies to capitalize on a market you may not have much conviction in. It can be especially useful when prices move “sideways”, meaning the market fluctuating within a tight range for an extended time without going in a particular direction. Prices oscillate within the borders of price support and resistance.Typically I have used grid trading for some altcoins for which staking was nonexistent or unrewarding. It has also been a source of revenue in trading BTC in recent extended ranges.
If you are a native crypto Hodler, you can set a grid with a large low-high range to keep a long position that will scale on the downside and take partial profits on the up side.
These strategies are versatile, suitable for short and long term strategies as well as long and short positions. You can even trade multiple trading grid strategies for different time horizons or directions and still for the same token. For instance, you can have a short term strategy on BTC with a grid from $15,000 to $19,000 with interval every 100$ for the coming months, but also a long term grid strategy $15,000 to $45,000 with a grid interval of 1000$ if you are a hodler and do not want to look at the market in the coming years. In short, they are customizable for all weathers.
It can help you profit from a market making strategy on specific or exotic coins with thin order books. As you are de facto providing liquidity, deepening the order book of very illiquid tokens by placing at the same time bids and asks, you will tend to benefit from that strategy converting spikes into profit.
Finally, the advantage of grid trading is that it removes emotions in your trading decision, conquering your worst enemy, FOMO. If you are already experimenting with trading, you know how your emotions can lead to suboptimal decisions.
But beware still, these strategies are still directional, they may not be rewarding if they do not fit your view (something that the CEXs obviously forget to tell you), and stop losses should still be in place.
How to set up a trading grid and what would be the revenue profile?
I am mainly looking at enhancing the performance of my directional views, assuming that the path to my Take Profit level will not be linear.
I will compute the intervals of my grid as a portion of the Average True Range (ATR), a useful and simple formula that can give you an idea of the average range of “tradability” for your time frame. I use ATR extensively in many aspects of my trading, to set a level of stop-losses that will not be triggered by “market noise” or compute options value for gamma trading, but I will probably explain this concept further in another article.
The Average True Range Formula was first introduced by J. Welles Wilder in his book “New Concepts in Technical Trading Systems” in 1978
The first step in calculating ATR is to find a series of true range values for an asset. The price of an asset for a given trading day is simply its high minus its low. Meanwhile, the true range is more encompassing and is defined as:
My favorite time period is 20, using daily data (roughly a month) for the purpose of manually trading grids for stocks. But it seems to work well for a shorter time frame with automated trading grids (hourly or 4 hourly for instance).
I will then set my grid interval at around 80 to 90% of this ATR(20) to increase the chance of churning trades daily.
For example,
Bitcoin (BTC) is now $17,000,
I decide to enter in a long position of 1 BTC
with a grid in range Low $17,000 — High $22,000
with a time frame of 6 months
ATR(20) = $625, I will probably set my interval at $500
Which means a number of intervals i=10
And a grid value of $50, as every $500 I will sell 0.1 BTC which I hope to buy back 500$ lower with noise.
Below is the comparison of my revenue profile between a simple long of 1 BTC vs my grid strategy if BTC goes straight to $21,000 without any chance to lock any grid in between.
That does not look that appealing at first, but the revenue profile of my grid strategy will shift higher depending on the number of grids I will manage to lock during my time frame. This will, as well, result in decreasing my Break Even point (price at which my revenue is flat), probably allowing me to keep my position longer.
It is important to judge the number of grids you will need to lock to generate a return which would have been equivalent to holding a long position to your initial target (here 22,000). I call it the “Implied Grid Number” (IGN).
IGN is in fact the result of a sum of a series of Natural Numbers starting from zero. I will not go in the details, but it is a nice brain teaser if you want to confirm my solution:
Thereafter, it is art, like always in trading. Your decision will depend on your own risk aversion.
When this concept is understood, we can then build desired revenue profiles by combining grids.
Can a trader build a PROFITABLE Delta-Neutral position?
For instance, I think the market will be rangy for my desired time frame without having a view of the direction of the market in that range. I can buy 1 BTC spot and sell its perpetual 1 BTC-PERP at $17,000. For the illustration we assume that they are trading at the same level, and I implement a grid for both sides with 10 intervals and the range $12,000-$17,000 for BTC-PERP and $17,000-$22,000 for BTC.
The profile of Revenue will then be the following depending on the number of grids traded in the range during my time frame.
What is the opportunity for Defi ?
First, automated grids are only available on CEXs or through bots accessing CEXs. In order to run your trading grids you will need to leave a pool on the exchange of both crypto from the pair you are trading. Not only will this pool not earn interest, but also fewer of us want to leave idle cash sitting on a CEX (this is when I repeat what you should know by now: “not your keys, not your coins”. In my example, a CEX will typically force you to leave a pool of BTC and Tether (USDT) on the exchange to facilitate the transactions of the grid until it is closed.
The second issue are transaction costs. The execution of your trading grid on a CEX will eat a big portion of your expected revenues, especially if the size of your intervals is small, even though only maker fees will be charged.
CEXs have fully understood this golden goose, and highly promote the usage of trading grids generating recurring fees as well as constant liquidity for their listed tokens. This is further marketed through competitions or copy-trading, as well as suggested ranges according to their so-called inhouse AIs.
Unfortunately, managing trading grids on Decentralized Exchanges (DEX) is not straight-forward. Only very few DEXs provide order books functionality like dYdX, and if so only on major PERPs. To my knowledge none of them propose grid trading. This forces me to manage my grid manually; this is tedious and limits me to grid intervals catering for daily fluctuations.
Which part of grid trading DEXs do not understand?
Grid trading is a simple and systematic way to enhance the return of your assets in a rangy and/or noisy market. It is versatile, customizable and can be easily automated. CEXs have for a while understood the benefit of trading grids to increase the depth of their order books and generate fees. We think that DEXs should explore these mechanisms to increase the depth of their order books. A must for this industry to succeed and take over CEXs. For that matter, any form of liquidity like the one I propose should be rewarded.
In our next publication, we will expose an elegant way to replicate a Trading Grid at lower cost: Using options.
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