Cryptocurrency arbitrage is the best way for investors to take advantage of the high crypto volatility to earn low-risk returns from high-frequency trades.
This trading strategy is one where both new and experienced investors take advantage of slight price variations of digital assets in crypto exchanges or trading platforms.
To put it simply, cryptocurrency arbitrage trading is the process of buying any token on one exchange where it’s cheaper and selling it on another platform where it’s higher.
By doing this, investors can earn money using a process that involves little or no risk.
Another good reason to try out this strategy is that you do not have to be a very experienced trader with a multi-million dollar setup to start cryptocurrency arbitrage trading.
What Is Cryptocurrency Arbitrage Trading?
The irony here is that cryptocurrency arbitrage has been around long enough, even since the emergence of the crypto market.
Despite the long history of this strategy, there seems to be even more hype surrounding its potential in the crypto space.
And this is because cryptocurrencies are generally known to be extremely volatile compared to other financial instruments like stocks and bonds.
This further means that cryptocurrency prices will definitely rise and fall over significant periods each year.
And because cryptos are traded 24/7 across a lot of exchange platforms globally, there are far more opportunities for cryptocurrency arbitrage traders to find so many opportunities to earn money from price variations.
All an arbitrage trader needs to do is go through 10 or more global exchanges to spot a difference in the pricing of tokens and execute some transactions to earn money from the price difference on each platform.
For example, let’s say I have over 12 exchange apps on my phone and while comparing the prices of tokens, I notice that Ethereum is $2,600 on the FTX cryptocurrency exchange and $2,350 on Binance.
In this situation, as a cryptocurrency arbitrage trader, after spotting this variation in price, all I have to do is buy Ethereum from Binance and sell it on FTX to make a cool $250 without taking any risk.
And this my dear friends, is the true definition of being a cryptocurrency arbitrage trader. No sweat, no risk, cool cash.
Why are crypto prices different on multiple exchanges?
To answer this question, we would need to understand what the following are:
- Centralized Exchanges
- Decentralized Exchanges
Centralized Exchanges
The first thing you need to know is that the price of assets on centralized exchanges depends on the last order, which corresponds to supply and demand in the exchange’s order book.
In other words, the last price at which a trader buys or sells a digital asset on an exchange is considered the real-time price of that asset on the exchange.
For example, if the $60,000 buy bitcoin order is the last matching order on an exchange, that price becomes the last bitcoin price on the platform.
The next matching order also determines the next price of the digital asset.
Therefore, pricing on exchanges is an ongoing process that determines the market price of a digital asset based on its last sale price.
Keep in mind that the price also tends to fluctuate as investor demand for an asset is slightly different on each exchange.
Decentralized Exchanges
Decentralized cryptocurrency exchanges use a different method to value cryptocurrency assets.
This method is known as an “automated market-maker” system and it relies directly on cryptocurrency traders to bring prices in line with those on other exchanges.
Instead of an order book system where buyers and sellers come together to trade crypto assets at a set price and value, decentralized exchanges rely on pools of liquidity.
A separate pool must be created for each cryptocurrency trading pair. For example, if someone wants to trade Ethereum (ETH) for (LITECOIN), they would need to find an ETH/LITECOIN liquidity pool on the exchange.
Each pool is funded by volunteer contributors who deposit their own crypto assets to provide liquidity for others to trade in exchange for a proportionate share of the pool’s transaction fees.
The main advantage of this system is that traders do not have to wait for a counterparty (an opposing trader) to buy or sell assets at a certain price. The operation can be performed at any time.
On the most popular decentralized exchanges, the prices of the two assets in the pool (A and B) are maintained using a mathematical formula.
This formula balances the financial situation in the group. This means that if a trader wants to buy Ethereum from the ETH/LITECOIN pool, they need to add LITECOIN tokens to the pool in order to remove the ETH tokens. When this happens, the asset ratio changes (more LITECOIN tokens in the pool and less ETH).
To restore balance, the protocol automatically lowers the price of LITECOIN and increases the price of ETH.
This encourages traders to remove cheaper LITECOIN and add ETH until prices realign with the rest of the market.
In circumstances where a trader significantly changes the relationship in a pool (executes a large trade), this can result in large differences in the prices of assets in the pool compared to their market value (the average price reflected across all trades).
Types of Cryptocurrency Arbitrage Trading Strategies
Cryptocurrency arbitrage traders can exploit market inefficiencies in a variety of ways. Some of them are:
- Cross-exchange arbitrage
- Spatial arbitrage
- Triangular arbitrage
- Decentralized arbitrage
- Statistical arbitrage
Cross-exchange arbitrage
This is the basic form of arbitrage trading, where a trader tries to profit by buying cryptocurrency on one exchange and selling it on another exchange.
Spatial arbitrage
This is another form of cross arbitrage trading. The only difference is that the exchanges are located in different regions. For example, you can use the spatial arbitrage method to capitalize on the difference between the demand and supply of bitcoins in the United States and South Korea.
Triangular arbitrage
It is the process of transferring funds between three or more digital assets on a single exchange in order to benefit from the price differential of one or two cryptocurrencies.
For example, a trader can create a trading cycle that starts with Bitcoin and ends with Bitcoin.
A trader can trade Bitcoin for Ethereum, then trade Ethereum for Cardano’s ADA token, and finally convert ADA back to bitcoin.
In this example, the trader has moved his balance between three cryptocurrency pairs: BTC/ETH → ETH/ADA → ADA/BTC.
If there are gaps in any of the prices of the three cryptocurrency trading pairs, the trader will end up receiving more bitcoins than when the trade started.
Here, all trades are executed on an exchange. Therefore, the trader does not need to withdraw or deposit funds on multiple exchanges.
Decentralized arbitrage
This arbitrage opportunity is common on decentralized exchanges or automated market makers (AMMs) that price cryptocurrency trading pairs using automated, decentralized programs called smart contracts.
When prices of cryptocurrency trading pairs differ significantly from their spot prices on centralized exchanges, arbitrage traders can step in and execute cross trades involving the decentralized exchange and centralized exchange.
Statistical arbitrage
It combines econometric, statistical, and computational techniques to execute large-scale arbitrage trades.
Traders using this method often rely on mathematical models and trading robots to execute high-frequency arbitrage trades and maximize their profits.
Trading robots are automated trading machines that execute large volume trades in record time based on predefined trading strategies.
Why Is Crypto Arbitrage Trading Considered To Be A Low/No Risk Strategy?
You may have noticed that, unlike day traders, crypto arbitrage traders don’t have to predict future bitcoin prices or take trades that can last hours or days before they start making profits.
By identifying and capitalizing on arbitrage opportunities, traders base their decision on the expectation of making a firm profit without necessarily analyzing market sentiment or relying on other forward-looking pricing strategies.
Additionally, depending on the resources traders have, it is possible to enter and exit an arbitrage trade in seconds or minutes. Taking these elements into account, we can conclude the following:
- The risk associated with crypto arbitrage trading is slightly lower than other trading strategies as it generally does not require forward analysis.
- Arbitrage traders only need to execute trades that last a few minutes at most, so the trading risk is significantly reduced.
However, this does not necessarily mean that crypto arbiters are completely risk-free.
Cryptocurrency Arbitrage Trading Risks
Certain factors can reduce a trader’s chances of winning. The low-risk nature of arbitrage opportunities affects their profitability; Less risk tends to result in smaller profits.
Because of this, cryptocurrency traders need to execute large transaction volumes in order to make significant profits. Also, arbitrage transactions are not really free.
Fees
Note that when trading arbitrage on two exchanges, withdrawal, deposit, and trading fees may apply. These charges may increase or decrease your earnings.
Using our original example as a case study, let’s say that Blockchain’s withdrawal fee, Binance’s deposit fee, and Binance’s trading fee add up to 2%.
The total cost of executing this trade is $45,000 + (2% * $45,000) = $45,900. In other words, the cryptocurrency trader must have suffered a loss since the potential gain is only $200.
To mitigate the risk of losses due to exorbitant fees, arbitrageurs can limit their activities to transactions at competitive prices.
They can also deposit funds on different exchanges and reorganize their portfolios to take advantage of market inefficiencies.
For example, Frank sees price differences between Bitcoin on Blockchain and Binance and decides to go all out.
However, instead of moving funds between the two exchanges, Frank already has funds in Tether (USDT) on Blockchain and 1 BTC on Binance.
All he has to do is sell 1 BTC on Binance for $45,200 and buy 1 BTC on Blockchain for 45,000 USDT.
At the end of this transaction, he still earns $200 and avoids paying withdrawal and deposit fees.
Here the only fees Frank has to worry about are trading fees. It is worth noting that trading fees are relatively low for traders executing large trading volumes.
Timing
Crypto arbitrage trading is time-sensitive. As more traders take advantage of a particular arbitrage opportunity, the price difference between the two exchanges tends to disappear.
Consider the difference in Frank and Sarah’s returns due to the timing of their trades. In this scenario, Frank is the first to identify and take advantage of the arbitrage opportunity in our original example. This was followed by an attempt by Sarah to do the same.
If Frank buys Bitcoin for $45,000 on Blockchain and sells it for $45,020 on Binance, Sarah can no longer execute that trade at exactly that price.
Due to the competitive nature of the market, Sarah may need to buy bitcoins on Blockchain for $45,005 and sell them on Binance for $45,015.
The convergence of bitcoin prices on Blockchain and Binance will continue until there are no more price differences to exploit.
The following are some of the factors that can negatively impact the time it takes to complete crypto arbitrage operations:
Blockchain Transaction Speed
Because you may need to cross trade, the time it takes to validate these transitions on the blockchain can hamper the effectiveness of your arbitrage trading strategy.
For example, it takes anywhere from 10 minutes to an hour to confirm transactions on the Bitcoin blockchain.
During this time the market may have moved against you. Therefore, arbitrageurs should stick to blockchains with high transaction speeds; or those that are not sensitive to network congestion.
Exchange AML Checks
It is common for exchanges to conduct anti-money laundering (AML) checks when large sums are moved by a trader. In some cases, these checks can last for weeks.
Therefore, before engaging in cross-arbitrage trades, you should consider the propensity of cryptocurrency exchanges to perform additional checks at the time of withdrawal.
Offline Exchange Servers
It is not uncommon for crypto exchanges to go offline. In some cases, cryptocurrency exchanges may even restrict withdrawals and deposits of certain digital assets for one reason or another.
When this happens, the ability to take advantage of arbitrage opportunities immediately decreases.
Security
Because arbitrage traders need to deposit large amounts of funds into exchange wallets, they are vulnerable to security risks associated with illegal exchanges and exit scams.
Exit scams occur when a company suddenly goes out of business and walks away with user funds.
With that in mind, it is wise to do your due diligence and stick to reputable cryptocurrency exchanges.
How To Start Cryptocurrency Arbitrage Trading
Whether you are a beginner or an experienced investor, the advantage of cryptocurrency arbitrage trading is that today there are several platforms that automate the process of finding and trading price differences on different exchanges.
These set it and forget it platforms can offer a great passive income opportunity for traders looking for a low-risk, contactless trading solution and include:
- Arbismart
- Pionex
- Cryptohopper
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