What Is Arbitrage Trading?

The aim of every investment is profit and investors carefully look for ways to maximize returns on investment. One such investment strategy is Arbitrage trading.

The concept of Arbitrage trading deals with market inefficiencies and price variations mostly exploited by sophisticated hedge fund investors and it is quite popular in the traditional market, that is among traders of stocks, bonds, and commodities who take advantage of price variation across two or more markets to profit from the slight price differences.

However, the idea is making inroads into the crypto industry and it is being exploited by crypto traders due to cryptocurrency price variations and the uncertainties inherent in the industry.

What Is Arbitrage Trading?

Arbitrage trading is an alternative investment strategy that involves the buying and selling of stocks, commodities, and currencies in different markets or crypto exchanges, quickly taking advantage of the slight price differences to generate profits.

Arbitrage trading is an opportunity in the financial markets that favors sophisticated investors and institutions who have high volume to maximize the opportunity provided by price differences, thereby, taking advantage of tiny differences in the price of identical or similar assets in different markets.

Crypto arbitrage is a product of supply and demand where arbitrageurs (that’s those involved in arbitrage) take advantage of price differences, or similar assets in exchanges.

Nowadays, with the advent of sophisticated technology, market prices are constantly monitored, with price adjustments across several markets, thus reducing the possibility for arbitrage. Though this has not eliminated the occasional occurrence of some types of arbitrage trading nor has it prevented some skewed investors from making quick cash.

How Does Arbitrage Trading Work?

Arbitrage trading is simply an exploitation of price differences in the financial market, using highly sophisticated software to receive signals of price variations from different markets.

For instance, a skilled investor carefully observes the price of 1 Bitcoin (BTC) in Exchange A to be $20,000, and at the same time, the price at Exchange B is $19,800. The investor can jump on this opportunity to make a profit off the difference by buying a huge amount of BTC on Exchange A and immediately selling them on Exchange B. The trader will significantly profit from these loopholes until market conditions change or the technicians on the affected market adjust their prices to eliminate the discrepancies observed.

What Is Cryptocurrency Arbitrage?

Cryptocurrency arbitrage is a strategy of earning money from the purchase of various cryptocurrencies from one exchange and selling them on another at a slightly higher price. In other words, it is the practice of profiting from buying coins on an exchange with a lower price and selling them on another exchange with a high price, and earning profit as a result.

For instance, Ethereum (ETH) could cost lower on Gate.io but the price on another exchange could be higher. Sophisticated Traders will seize this opportunity to make a good profit.

Therefore, to profit, you must purchase coins from the exchange with a lower price; sell them as soon as possible at another with a higher price, and save the difference. The price discrepancy may only exist for a brief period as numerous factors including varying levels of activity and differences in supply and demand on various exchanges can lead to price swings.

Types of Arbitrage Trading

There are several types of Arbitrage Trading that touch on different financial investments. Let us focus on the most basic types:

Crypto Exchange Arbitrage

This simply involves buying coins on one exchange at a low cost and selling them on another at a high cost and then keeping the profit from the slight price difference between the two. For instance, the price of Ethereum (ETH) in Gate.io could be $1780 and cost slightly higher than $1800 in another exchange. Investors can earn a profit of $20 for every ETH sold. Profits are generally very small in arbitrage trading, hence, the volume per trade and the speed of transaction is very important, the reason most arbitrage trading is executed by algorithms created by high-frequency trading (HFT) firms.

Currency Variations

Another way involves simultaneously placing transactions in two currency pairs, buying one and selling the other to take advantage of the difference in prices. This is currently a big business in developing countries where there is market inefficiency and fluctuations of local currency.

These countries heavily depend on foreign currencies for importation and aid, thus placing pressure on their weak currency and creating an opportunity for arbitrage trading.

Triangular Arbitrage

Triangular arbitrage, also called Three-point arbitrage or cross-currency arbitrage, is a complex strategy of buying and selling three different currencies (digital or fiat) and making a profit from the sale.

Using cryptocurrency, for example, an arbitrage opportunity involving Bitcoin, (BTC), Ethereum (ETH), and Solana (SOL) may be seen by a skilled trader. The exchange may have an inflated price for one or all of these cryptocurrencies. Therefore, a trader takes full advantage by exchanging BTC for ETH, then using that ETH to purchase SOL, before finally purchasing BTC with the acquired SOL. The trader ends up with more BTC than at the beginning.

The profit you make from this trade is produced by the difference in the three pairs’ exchange rates by exchanging the third currency for your original asset.

Statistical Arbitrage

There are larger profits to be earned from that crypto that did well, a bot awards a low score to a cryptocurrency that has done very well and a high score to the one that has performed poorly. The trading algorithm, a constructed mathematical model that can accurately trade cryptocurrencies between one another for your benefit is displayed on the board which makes it easy to choose from.

Decentralized Finance (DeFi) Arbitrage

DeFi is a non-custodial financial protocol that exchanges with zero human interference. Their coding architecture makes them ideal for arbitrage; “DeFi degens” who want to try arbitrage can use this platform. They use smart contracts for trading.

The various returns provided by DeFi lending methods are one of the best ways for arbitrage. A trader might switch their low-yield stablecoin to a high-yield one to earn that extra 1% if one platform provides a 10% yield from one stablecoin while another platform offers an 11% yield from a different stablecoin.

Which Technology Should Be Utilized in Cryptocurrency Arbitrage?

The most convenient and effective cryptocurrency arbitrage apps for arbitrage operations — with a lot of them free to use — include Coingecko, CoinDesk, and CoinMarketCap. They offer up-to-date information on the cryptocurrency market, allowing you to track price changes across exchange listings and seize opportunities for all kinds of altcoins.

Also, there are cryptocurrency arbitrage calculators and portfolio trackers like Blockfolio (now FTX) and CoinStats that let you monitor cryptocurrency pair prices across many exchanges. You can check them out and choose which is the best for you.

Advantages of Using Automated Crypto Arbitrage

Automated crypto-arbitrage algorithms can scan many exchanges at once while tracking hundreds of cryptocurrencies. A massive number of trades are scanned simultaneously with speed and efficiency that no human can match.

It does not involve financial expertise, no time-consuming research into price discrepancies or trading activity on exchanges with large and low trading volumes, or hours spent in front of a computer screen placing transactions.

Risks Involved in Crypto Arbitrage Trading

Crypto arbitrage is less risky compared to its traditional counterparts — commodities, bonds, and stocks — because it takes advantage of the volatile crypto market and price discrepancies between similar currencies across two or more exchanges and does not involve price prediction or assumptions. This does not preclude the fact that some risks are not imminent when dealing with crypto arbitrage. So, what are some risks to look out for?

• Slippage: This takes place in centralized exchanges that use order books to carry out transactions and regularize prices. It happens when the order “slips” and ends up costing more than the trader had anticipated when the trader sets a purchase order for a cryptocurrency that is greater than the cheapest offer in the order book. The fact that the margins are so low and slippage might eliminate prospective earnings makes this an issue for traders.

• Price fluctuations: This poses an opportunity to make profits but delayed transactions could lead to price adjustment and normalization. To take advantage when they occur, traders must act quickly by having cryptocurrency in the exchanges and carrying out transactions with blockchains that process transactions very fast.

• High transaction fee: This could wane the chances of crypto arbitrageurs making profits, as withdrawal, deposit, and trading fees could eat up the entire profit, the main reason for the investment. So, those who benefit from arbitrage trading regardless of fees are hedge fund traders, as transaction fees are relatively low for traders carrying out high volumes of trades.

• Delay transactions: Delay in transactions could lead to losses as some window of arbitrage is open for a short time, and as more traders hop in the sooner the price normalizes. Therefore, cashing in on price differences strongly depends on how fast you move funds from one exchange to the other.

• Hacking of wallet address or closure of crypto exchange: Either of these causes great loss to traders. Hot wallets are very susceptible to cyber security breaches and there are several instances where crypto exchanges have shut down stealing customers’ funds. Hence, the need to store the bulk of your crypto assets in cold wallets and to trade with well-established exchanges like Gate.io.

Is Crypto Arbitrage Still Profitable?

Generally, the supply and demand of similar assets lead to price variations across different markets, locally and internationally, leading to an opportunity to earn through the price gap. For instance, in the first crypto boom (2017 - 2018), it was easier to profit from arbitrage strategies, because the concept was relatively new in the crypto industry and price normalization took days and sometimes weeks.

Today the market has evolved and it is more complicated to make a profit; though skilled investors and hedge fund traders still boost great returns through arbitrage.

Conclusion

Arbitrage trading has profited not only investors but also traders — through the use of mechanisms to ensure that the price does not deviate considerably nor linger for long. Hence, the deployment of advanced technology to constantly monitor price variations across several markets and rapidly adjust them provides for a drastic reduction of price discrepancies in the market.