Arbitrage is a trading strategy where traders take advantage of slight differences in the price of assets between multiple trading platforms. This way, an "arbitrageur" can make small profits on each trade with very little risk.
This guide contains everything you need to know about cryptocurrency arbitrage. Here, we will explore the different trading strategies in crypto arbitrage and the risks associated with this method of trading.
Let's start with the basics of crypto arbitrage - what it is and how it works.
First, crypto arbitrage trading is unlike other forms of investing in digital currencies, which leaves you open to losses from the volatility of the crypto market.
Instead of directly trading high volatility, you profit from temporary price inefficiencies across different crypto exchanges. Simply put, cryptocurrency arbitrage is exploiting the fact that, over a short period of time, a coin can be available on different crypto exchanges at different prices at the same time.
To make a profit, you buy a coin on the exchange with the lowest price, then sell it instantly on the exchange with the highest price and profit off the difference. The price disparity may not last very long, so you need to seize the opportunity before the market corrects itself and the inefficiencies are eliminated. The difference in price can be caused by a number of reasons, such as different levels of activity and differences in supply and demand on different exchanges.
For example: Let's assume Bitcoin is worth $20,000 on Binance and $20,860 on Coinbase. In this case, you could buy half a BTC on Binance and sell it on Coinbase for a profit of $430.
Arbitrage trading has existed long before the emergence of the cryptocurrency market. However, there seems to be a lot of potential for this trading strategy in the crypto scene. This is due to the high volatility of cryptocurrencies and this gives investors more opportunity to benefit from slight price differences across multiple platforms.
On centralized crypto exchanges (CEX), the price of cryptocurrencies depends on which bid was last in the order book. So the last price at which a trader buys or sells a cryptocurrency is considered the real-time value.
For example, if the last order for Bitcoins is $27,000, then this will be the price of BTC for a while. However, if another investor buys $27,200 in Bitcoin, the value of the Bitcoin will increase by $200. Centralized exchanges rarely have exact prices for their coins, so you will always find a small or large discrepancy between crypto platforms.
Decentralized exchanges (DEX) use a different method of pricing cryptocurrencies than centralized platforms called the "Automated Market Maker" system. It relies directly on crypto traders to keep prices exactly as they are displayed on crypto exchanges.
Instead of an order book system, DEX uses pools of liquidity to determine the value of a token. A separate pool must be set up for each crypto trading pair. For example, an investor who wants to trade Tether against Bitcoin needs to create a USDT/BTC liquidity pool or link it to the decentralized crypto exchange.
The advantage of this system is that traders do not have to wait for a counterparty (a seller or a buyer) to complete the transaction. So if an investor wants to buy BTC from the USDT/BTC pool, they need to add USDT to remove BTC. After that, the ratio of tokens changed, and the protocol automatically lowers the price of bitcoins. This is where investors can participate in arbitrage crypto trading: when the price falls on one crypto exchange but stays the same on another.
Investors have three trading strategies that they can use in arbitrage. Let's analyze how they work in detail.
Capital = $10,000
On Exchange A, 5 ETH = 0.4 BTC.
On Exchange B, 0.4 BTC = $10,060.
On Exchange C. $10,060 = 88.25 BCH
On Exchange A, 88.25 BCH = $10,413.
Overall Profit = $413
It is no secret that BTC is the most profitable speculative asset that has withstood the test of time. Some other coins are also quite interesting for any active investor looking to expand their portfolio or make a quick profit.
The general strategy for Bitcoin arbitraging looks like this:
It is theoretically possible to use this in a bitcoin futures arbitrage strategy, but using leverage just adds another level of risk to a method that already carries inherent risk.
The process seems quite simple and requires little to almost no technical- know-how. The problem here is that orders must be placed at the same time to counteract any volatility affecting both exchanges. Not only is this difficult to achieve manually, but you may also be absent when the perfect opportunity presents itself. Because prices reset quickly when so many traders are involved, you have tiny windows for good order placement when dealing with highly demanded assets.
On the other hand, you can increase your chances of finding good arbitrage opportunities by using little-known coins and tokens. However, you are unlikely to be able to track the prices of several altcoins for a long time.
Unlike day traders, arbitrageurs do not have to rely on predicting the future price of cryptocurrencies to make a profit. Instead, they focus on identifying opportunities in the market and capitalizing on them. Arbitrage allows investors to calculate their profits in advance, reducing risk before executing a trade.
Additionally, with arbitrage, traders complete trades in seconds or minutes, limiting the time their position is exposed. This continuous cycle of short trades via arbitraging minimizes potential losses while at the same time pushing for profit. However, lightning price drops can hurt profits and cause investors to hold their positions until the asset recovers its value.
Even though crypto arbitrage is inherently very low risk compared to speculative investing in digital currencies, there are a number of factors to consider in order to effectively protect your capital.
Several factors can reduce an arbitrageur's chances of making money. Although the trading strategy has low risk, the profits tend to be sub-par compared to other methods. Therefore, arbitrageurs need to generate a high volume of trades in order to make big profits. Let's see what can affect profits with this trading strategy.
Crypto Arbitrage trading is highly dependent on timing. When multiple traders spot an opportunity for a particular asset, the price differential between crypto exchanges quickly disappears.
Most traders set alerts to have a first-mover advantage. However, there is often insufficient time to execute the trade and make the biggest profit. This is because trading bots are becoming more and more advanced and can execute thousands of trades per second, making it difficult to turn a profit with a hands-on approach.
Different fees may apply depending on the arbitrage strategy you are using. For example, when trading arbitrage on different exchanges, you have to pay order costs each time you execute a trade. Depending on the fee structure of the crypto exchanges, these costs can add up and reduce profits.
Since you need to open accounts and deposit funds on multiple crypto exchanges, you are vulnerable to exit scams and hacking attacks. An exit scam is when a company suddenly goes out of business and steals customers' money. It is therefore advisable to only use regulated platforms and to research each provider thoroughly before signing up. You can also use our list of crypto platforms that are verified and trusted providers.
The crypto market is very volatile, so sudden price drops are not uncommon. Unfortunately, a sudden price change can be triggered by various factors. For example, world news events, new crypto laws, or investors selling off their profits. It is pretty common to buy an Altcoin and experience a sudden drop and dump in price which means a massive loss if you decide to sell immediately. In this case, you have no choice but to wait for the price to pump again.
Crypto arbitrage is becoming more and more popular not only among retail investors but also among hedge funds, financial institutions, and investment companies. It requires minimal effort and offers high returns, providing the speed and profitability of cryptocurrencies with almost zero risk.