When an asset is bought in one market and immediately sold in another at a higher price, taking advantage of the price differential to make a profit, this trading strategy is known as Arbitrage. It must occur in the presence of at least two comparable assets with varying prices. In essence, arbitrage is a situation in which a trader can profit from a disparity in asset prices between markets. The most basic form of arbitrage is buying an asset in a market where the price is lower and selling the asset in a market where the price is higher.
Arbitrage trading is a profitable trading strategy that involves simultaneously purchasing an asset in one market and selling it in another. The most frequent use of this is when trading identical assets on various exchanges. Arbitrage is a popular trading strategy and is assuredly one of the oldest trading strategies. Traders who employ the strategy are referred to as Arbitrageurs.
How Does Arbitrage Work
Generally, arbitrage's success depends on the financial market's inherent inefficiencies. Markets are driven by supply and demand, and changes in either can affect the price of an asset. Similarly, the same principle holds with crypto arbitrage; this means the ask-bid match orders drive the market, and the discrepancies in the order are the leverage for arbitrage.
As a result, crypto arbitrageurs seek to profit from short-term differences in the market-matched orders of an asset. They are looking for price differences that can occur when there are differences in supply and demand across exchanges. These differences typically don't last very long because speed and timing are essential. However, if the arbitrageur timed the market correctly, the profits could be enormous.
Let's say, for illustration purposes, that bitcoin costs $20,000 on Exchange A and $20,150 on Exchange B. Crypto arbitrageurs might notice this discrepancy and buy bitcoin on Exchange A before selling it on Exchange B to make $150 in profit. This is precisely how crypto arbitrage works.
Furthermore, crypto arbitrageurs can set up and benefit from an automated trading system –bots– as part of an arbitrage trading strategy. The trading bot relies on algorithms to detect price differences, allowing a trader to capitalize on the market and maximize the trade for profit.
Unlike other crypto traders, crypto arbitrageurs are not required to predict the future prices of cryptocurrencies or spend hours studying price charts. They also don't trade when the time frame for profit is extended to hours or days. Crypto arbitrageurs can expect a fixed profit by identifying arbitrage opportunities and taking advantage of them without necessarily studying the market or using other predictive pricing strategies.
Types of Arbitrage
Purchasing a cryptocurrency on one exchange, then transferring it to another exchange where it is sold at a higher price is one form of crypto arbitrage trading. Due to cryptocurrency volatility, the value can fluctuate rapidly and sometimes instantaneously. However, looking at the ask-bid matched order for the same asset on different exchanges, you'll discover that the prices are rarely the same during the same period. This is where crypto arbitrageurs try to profit from these minor differences. As a result, the underlying market becomes more efficient because prices remain relatively contained across trading venues.
There are a few challenges with this strategy, though. While moving money between exchanges can take several minutes, market spreads typically last only a few seconds. Transfer fees are an additional issue. Moving cryptocurrency from one exchange to another costs money through withdrawal, deposit, or network fees.
Triangular arbitrage is another popular type of arbitrage trading in the cryptocurrency world. This method entails trading the difference between three cryptocurrencies on a single exchange. As the name implies, it's a transaction that involves three different assets. For example, a trader may see an opportunity in Bitcoin, Ethereum, and Dogecoin arbitrage. On the exchange, one or more of these cryptocurrencies may be undervalued. So a trader could profit from arbitrage opportunities by selling Bitcoin for Ethereum, then using that Ethereum to buy Dogecoin, and finally repurchasing Bitcoin with Dogecoin. If their strategy works, the trader will end up with more Bitcoin than they started.
Statistical arbitrage is a difficult trading strategy because it requires mathematical modeling to trade hundreds of options in a short period; it uses data models and trading bots. A statistical arbitration bot may trade hundreds of different cryptocurrencies simultaneously, carefully calculating the likelihood that a bot will profit from trade using a mathematical model and going "long" or "short" on a trade. Major coins take about 15-20 minutes to confirm the transaction. If the market price falls within this time frame, you risk generating less arbitrage.
Risks Associated With Arbitrage Trading
Arbitrageurs must know the transaction fees associated with buying cryptocurrencies on different trading platforms. These fees are constantly changing and differ between exchanges. This can be a very subtle obstacle for arbitrage. Because arbitrageurs frequently make small profits, any exchange, network, or trading fees can reduce the arbitrage's profitability or even result in losses.
Execution risk occurs when you cannot complete the arbitrage transaction within the specified time frame. If the price difference between two exchanges changes before the transaction is completed, you may face negative returns. Slippage, slow execution, unusually high transaction costs, and a sudden increase in volatility could all be to blame.
Liquidity risk is a significant danger associated with arbitrage trading. This occurs when you cannot enter and exit the markets you need to trade to complete your arbitrage due to a lack of liquidity. It happens when you cannot sell the cryptocurrency as intended on the second exchange. You might experience difficulties purchasing and selling the assets if the markets do not operate as efficiently as possible.
Cryptocurrency arbitrage can result in financial gains for those involved with the right equipment, approach, and knowledge. Moreover, arbitrage in cryptocurrencies is possible when the markets show anomalies. As a result, arbitrageurs can achieve incremental gains, which add up over time. Furthermore, to profit from cryptocurrency arbitrage, you must carefully plan your trading strategies and consider all relevant trading-related factors, such as fees, transaction volumes, and completion times.