What Is Cryptocurrency Arbitrage?
To understand what cryptocurrency arbitrage is, we are first introducing the concept of arbitrage. Imagine that you’ve just bought a pencil for $10, which you then sold to someone else for $11. You would make a profit of $1 by simply trading it for a higher price. This model of trading is known as arbitrage. Arbitrage is a technical term given to the old basic practice of buying a product for a lesser price and selling it for a higher price. It’s different from regular crypto trading, as you have to wait for the price of the product to rise in the future with regular trading, yet with arbitrage, you simply sell the product where it is already valued at a higher price. For a number of reasons, the price of a crypto coin is not always the same on different exchanges. This allows you to buy a coin at a cheaper price from one exchange and instantly sell it for a higher price on another exchange: a process known as cryptocurrency arbitrage. In crypto markets, traders use arbitrage opportunities by buying and selling crypto assets on various exchanges to profit from different prices for the same asset.
Why Are Crypto Exchange Prices Different?
Various factors influence the differences in crypto exchange prices. The most common factors are:
Liquidity and fluctuation in trading volumeRecent bid and centralized exchangesLiquidity pools and decentralized exchanges
Let’s discuss these factors in detail.
Liquidity and Fluctuation in Trading Volume
The value of virtual currencies is based primarily on the trade volume, which is the cornerstone of crypto arbitrage and the primary reason for variable prices on various exchanges. Cryptocurrency is not tied to fiat money, such as the US Dollar or the Euro, nor is it associated with any one nation or exchange in particular. As with other commodities, supply and demand for cryptocurrencies like Bitcoin vary based on the market and the time you decide to make a purchase or sale.
Recent Bid and Centralized Exchanges
The core principle of trading on centralized exchanges is that the latest bid-ask paired request on the exchange order book determines how much an asset will cost. Simply put, the real-time price of an asset on a centralized exchange is determined by the price at which it was traded most recently. Since the prices at which Bitcoin is purchased on an exchange can be different from one exchange to another, the price of Bitcoin also varies slightly on every platform.
Liquidity Pools and Decentralized Exchanges
Decentralized exchanges operate in a diametrically opposite manner, where the goal is to make the prices similar to the ones shown across other exchanges. Therefore, this system relies on crypto arbitrage traders to stabilize the price of a digital currency. Decentralized exchanges use liquidity pools instead of an order book system where crypto assets are traded at a certain price. Every crypto trading pool is unique. Therefore, if someone wanted to trade Bitcoin (BTC) for Ethereum (ETH), they would need to search for a BTC/ETH liquidity pool on the exchange. Each pool relies on funds from generous contributors who introduce their crypto assets to serve as liquidity in exchange for a specified share of the pool’s transaction fee. In reputable decentralized exchanges, the value of these crypto assets is regulated through a mathematical formula that keeps the pool’s asset ratio steady.
Best Crypto Arbitrage Trading Strategies
Let’s go through some of the most common, viable crypto arbitrage trading strategies.
1. Simple Arbitrage
Simple arbitrage is among the most convenient and feasible trading strategies. It involves buying crypto on one exchange at a lower price and selling it on another for a slightly elevated price to generate profit. As it is fairly low risk and easy to execute, other arbitragers can take advantage of the same opportunity.
2. Decentralized Arbitrage
The decentralized arbitrage strategy relies on using smart contracts to determine the price of crypto trading pairs. If these pairs’ prices on decentralized exchanges (DEXs) diverge noticeably from those on centralized exchanges, crypto arbitragers can take advantage of this situation to conduct cross-exchange transactions for profit. Traders can use DEX to set up trading pools between any two cryptocurrencies. By using three distinct trading pools, a trader can swap currency X for currency Y, then Y for currency Z, and lastly, Z for X. There is an arbitrage opportunity, as the exchange rates for each trading pool are independent. Also, the three changeable currency rates aren’t perfectly synced together. Overall, decentralized arbitrage is very similar to simple arbitrage except for where it’s limited to decentralized exchanges and smart contracts.
3. Triangular Arbitrage
Triangular arbitrage involves shifting money across three or more digital assets on a single exchange to profit from the difference in price between one or two cryptocurrencies. For instance, an arbitrage opportunity exists when the BTC/DAI pair is trading at 40,000 DAI, and one ETH equals 3,000 DAI, but the BTC/ETH pair is inefficiently priced at 40 ETH instead of 35 ETH. Moving on, you can follow a simple strategy. Firstly, deposit funds to the exchange and purchase 1 BTC for 40,000 DAI, then trade the BTC/ETH pair to convert the BTC into 40 ETH. Finally, sell the 40 ETH for 50,000 DAI. At the end of the process, you could make 10,000 DAI in profit on three transactions with a 20% ROI. However, for this strategy to work, it’s very important to seize this rare chance immediately before the exchange’s algorithm promptly fills the price gaps.
4. Statistical Arbitrage
Let’s say Elon Musk or another influential person in the crypto market announces plans to dive into the NFT sector. The next thing we know the price of NFT project coins will start pumping hard.
If you’re going to apply the statistical arbitrage strategy, you’ll have to pick a pair of NFT coins with a strong correlation and very similar fundamentals, like $MANA and $SAND.
To select these pairs, automated systems run a check based on a number of leading indicators, like volume and even price action, then the trending coins are ranked based on these scores, and those that rank the lowest are bought, while those that rank on top are shorted.
If you notice that one of these coins is outperforming the other, you’ll need to buy the lower-valued coin in the hope that it will rise to the level of its outperforming partner while also shorting the ascending coin. Lastly, you need to wait for the prices to fluctuate again so that the two prices converge, and you can make a profit from the following reversal.
Why Is Crypto Arbitrage Considered a Low-Risk Strategy?
Crypto arbitrage traders are usually novice investors looking for quick short-term profits without caring about market conditions. They differ significantly from day traders, who rely on accurately predicting crypto prices. The conventional methods of generating profit from crypto trades are complicated and require adequate experience and a maturation period. Conversely, cryptocurrency arbitragers profit from the chance to make money by utilizing market price disparities. This is a safer and more reliable method, as it doesn’t rely on predictive pricing strategies or analyzing market sentiments.
Crypto Arbitrage Trading Advantages
Apart from being a low-risk strategy, there are other reasons why you may want to consider arbitrage trading:
Crypto’s juvenescence: trading in cryptocurrencies is highly unregulated and fragmented, and data is sent slowly across exchanges. Compared to many major investment markets, there are fewer traders and less competition, which can all result in greater arbitrage possibilities.
Assortment of exchanges: there are over 380 exchanges globally to efficiently trade crypto. This immense variety, coupled with crypto’s great volatility, gives rise to greater potential for the price differential.
Swift profit: compared to the conventional strategy of purchasing bitcoin, keeping it, and then selling it later, this presents the opportunity to make gains considerably more quickly.
Crypto Arbitrage Trading Risks
Just as with other forms of investment, arbitrage trading has its fair share of drawbacks:
Levied charges: it is crucial to know that arbitrage trading may incur fees. This trading, withdrawal, or deposit fee can add up and dramatically reduce your profits. Although high-volume traders experience low fees, investors need to carefully analyze the profitability by keeping these factors in their calculations.KYC rulings: regulations requiring “Know Your Customer” (KYC) checks may make it difficult to access many exchanges. For instance, to place trades, you may need to have a bank account in the nation where the exchange is located.
Blockchain transaction speed: cross-exchange transactions rely heavily on the time it takes to validate these transitions, which can significantly affect the efficiency of arbitrage trading. For instance, Polygon may take five minutes to one hour to verify transactions. In the meantime, the market can move against you. Therefore, arbitrage traders should adhere to blockchains that have fast transaction rates.
Volatility and time constraints: due to the extreme volatility of cryptocurrencies, the price may drastically fluctuate while you are transferring money across exchanges.
Image credit: Infrarate via Unsplash. All screenshots by Ojash Yadav.
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