What is Arbitrage Trading

Arbitrage Trading Explained

Ever wondered why a cryptocurrency’s price differs from one exchange to the other? This may seem unusual at first, but it’s quite common for any asset that trades on an open, global market. For example, when Bitcoin rose to all-time highs in 2017, data shows that one exchange may offer $19,600 for a bitcoin while another exchange offers more than $21,000.

Savvy traders, known as arbitrage traders, know how to take advantage of these small price discrepancies, and they can turn a potential profit from buying and selling the same asset on different markets.

In traditional finance, arbitrage opportunities exist for securities, commodities and currencies traded on different global markets. (The price of a stock may differ between the New York Stock Exchange, the Tokyo Stock Exchange and the Philippine Stock Exchange.)

Meanwhile in cryptocurrencies, traders find arbitrage opportunities by purchasing and selling crypto assets across different exchanges, allowing them to capitalize on different prices for the same asset. Do note that transaction costs and exchange fees can negate the gains made from these trades.

Defining Arbitrage Trading

Cryptocurrency arbitrage is a strategy in which investors buy a cryptocurrency on one exchange, and then quickly sell it on another exchange for a higher price.

Arbitrage has been a mainstay of traditional financial markets long before the emergence of the crypto market. And yet, there seems to be more hype surrounding the potential of arbitrage opportunities in the crypto scene.

This is most likely because the crypto market is renowned for being highly volatile compared to other financial markets. This means crypto asset prices tend to deviate significantly over a certain time period. Because crypto assets are traded globally across hundreds of exchanges 24/7, there are far more opportunities for arbitrage traders to find profitable price discrepancies.

All a trader would need to do is spot a difference in the pricing of a digital asset across two or more exchanges and execute a series of transactions to take advantage of the difference.

For example, let’s assume the price of bitcoin is $45,000 on the Coinbase cryptocurrency exchange and $45,200 on Kraken. In this scenario, crypto arbitrageurs might spot this disparity and buy bitcoin on Coinbase and sell it on Kraken to pocket the $200 price difference. This is a typical example of a crypto arbitrage trade.

Why are crypto exchange prices different in the first place?

Crypto markets are not regulated, and cryptocurrencies are decentralized and therefore — with the exception of stablecoins — are not pegged to government or fiat currencies like the dollar. This is one of the primary reasons why the prices of different crypto can vary widely: there is no standard price for any particular coin or token.

Related to this, some crypto exchanges are bigger than others, with higher trading volume. Thus the supply and demand on one exchange could be quite different from another, affecting the price.

Finally, crypto trading fees also vary, and can add to the cost of your trades.

Types of crypto arbitrage strategies

With the high volume of crypto traffic nowadays, arbitrageurs have developed strategies they can profit off of the market discrepancies. These are:

1. Cross-exchange arbitrage

The trader buys a crypto asset on one exchange and sells it immediately on another exchange where the price is higher. This is possible because the same asset prices can vary from one exchange to another. The trader needs to have accounts on both exchanges and be quick to take advantage of the price difference.

2. Spatial arbitrage

This involves buying and selling cryptocurrencies in different locations around the world to earn a profit. One example of a place where this could be profitable is Japan, which has a much higher demand for cryptocurrency than most other countries. By buying and selling cryptocurrency in Japan, you can earn a profit while avoiding the risks associated with investing in cryptocurrencies overseas.

3. Triangular arbitrage

Triangular arbitrage is a type of crypto arbitrage that uses the price of a digital asset to speculate on the price of another digital asset. This technique can be used to make money by trading one asset for another and immediately selling the second asset for a higher price. The idea is to exploit the difference in prices between the two assets to make a profit.

Is crypto arbitrage trading really profitable?

Like every other trading strategy, crypto arbitrage has helped traders earn profits from the crypto market. Every day, there are significant differences in the ask-bid prices of crypto assets, even among popular exchanges.

On average, crypto arbitrage trades can earn profit margins between 0.2% and 2.5% ($10 to $50) daily. However, there are occasions where there are large differences in spreads offering traders the opportunity to make decent profits, but this doesn’t happen every day. Arbitrage traders are often day traders who usually focus on the differences in spreads daily.

An important aspect of arbitrage trading is quick execution–when traders spot differences in prices across exchanges, they quickly decide to buy or sell the crypto asset. The volatility of the crypto market makes quick response pertinent for successful arbitrage trading as the price differences can be wiped out with significant delays.

Considerations in crypto arbitrage trading

If you are new to crypto arbitrage trading, here are a few things you need to consider:

  • Fees — It is important to consider fees in your trading equation, as they can negate any potential profits. For example, fees on Kraken range from 0.1% to 0.26%, so, you may want to avoid arbitrage differences lower than 0.30%.
  • Volume — The higher the trading volume on a cryptocurrency, the higher the liquidity of that coin, which increases the probability of your trades being executed.
  • Avoiding Slippage — Price slippage occurs when you get a different price than expected on an entry or exit from a trade. Thus, extensive research and perfect timing of the market becomes a crucial component of arbitrage trading.

Final Thoughts

Crypto arbitrage still seems to be a viable strategy for those looking to make money in the crypto space in 2022. While there are some challenges, such as increased regulation and volatility, it appears that arbitrage is still a viable way to make a profit. So if you’re looking to make some extra cash in the coming year, keep an eye on prices and see if you can take advantage of any opportunities that arise.

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