What is Arbitrage Trading?

In Guides

Arbitrage trading is a common strategy in the trading world that is primarily common amongst large finance institutions. It is s a relatively low-risk trading strategy that takes advantage of price differences across markets. Arbitrage trading continues to attract crypto traders and investors in large numbers.

In this guide, Liquid wants to discuss arbitrage trading strategies and explain how you can use them to your advantage and benefit from their short-term gains. 

What Is Arbitrage Trading?

Arbitrage trading is a strategy that aims to generate profit from the price difference of an individual asset on two or more exchanges.

For instance, let’s consider an asset called A and two exchanges called M1 and M2. It is possible that the price of A on the M1 exchange may be different from the price of A on the M2 exchange.

An arbitrage trader will notice this price difference, buy A at a lower price on the exchange M1, and sell it for the higher price on the M2 exchange, generating profit on the price difference. However, this price difference is often relatively low.

Even though arbitrage trading is subject to high transaction fees and demands more significant capital, many traders consider arbitrage a low-risk trading strategy.

How Does Arbitrage Trading Work with Crypto-assets?

You can make use of the arbitrage trading strategy by buying and selling crypto assets. In the context of cryptocurrencies, a trader may have to deal with multiple exchanges.

Let’s consider an example of Bitcoin (BTC), which is available to trade on almost all major exchanges, including Liquid

In crypto arbitrage trading, the trader must observe Bitcoin price fluctuations on multiple exchanges and notice even the slightest price difference.

Based on these observations, a trader will buy Bitcoin at a lower price from one exchange and sell it for the higher price on another exchange. The trader must consider transaction fees that incur on all these exchanges while calculating the final profit margin.

As long as the trader pays attention to the accuracy of numbers and transaction fees, arbitrage-trading a considerable amount of Bitcoin may generate a considerably massive profit.

There are a few conditions that need to be taken into consideration:

  1. The trader must be able to sell the exact amount of Bitcoin through the second exchange. Problems with the liquidity of BTC will impact whether a trader can earn a profit.
  2. The arbitrage-trading transaction must not take more time than expected. A trader can earn a profit only if the spread (price difference between two markets) exists.
  3. The price difference of BTC between the first and the second exchange must be more extensive than what you spend on transaction fees.

If the arbitrage-trading transaction can meet these conditions, the trader will receive more money than what they invested in the first exchange to buy Bitcoin.

While this remains the most popular concept behind arbitrage trading, there are some derivatives.

Types of Arbitrage Trading

Like in other industries, different types of arbitrage trading options are available in the crypto market. All of these types focus on one aspect of crypto-assets or the other. To give you an idea of how much choice you have, we will look at the three significant types of arbitrage trading in crypto.

  • Exchange Arbitrage

We already mentioned this type of arbitrage trading. As the name suggests, this trading technique tries to find the price differences between two cryptocurrency exchanges of an asset.

In this case, the asset could be anything, ranging from a popular cryptocurrency coin to a rising crypto token. The idea is to buy the crypto-asset from the exchange where the price is lower and sell it on an exchange where the price is higher. 

The price difference happens because exchanges take time to update the live price of an asset. Therefore, if the arbitrage trader can notice this discrepancy and act quickly, they will have a massive sum at their disposal.

  • Funding Rate Arbitrage

This type of arbitrage trading focuses on the potential growth a cryptocurrency can have. The trader would use a futures contract to hedge the potential price exposure. In this kind of arbitrage trading, the profits are based on the funding rate of the agreement.

If the contract pays you 3%, you will have that amount for just owning the cryptocurrency. Traders make use of futures contracts if they predict the value of the crypto-asset to fluctuate a lot. 

  • Triangular Arbitrage

If exchange arbitrage involves multiple exchanges that sell a single cryptocurrency, triangular arbitrage uses different cryptocurrencies and exchanges. As the first step, the trader has to select the cryptocurrencies that they want to trade.

You can consider BTC, LTC, and ETH for this example. First, the trader would use BTC to buy LTC from an exchange. Then, they will use the LTC to get ETH from the same/different crypto exchange. Finally, the trader will buy-back the initial amount of BTC using ETH. 

The critical factor would be the price difference between the BTC-ETH pair with LTC. As with the other types of arbitrage trading, even the slightest differences in pricing and micro-seconds of time can matter in these transactions.

Disadvantages of Arbitrage Trading

We already saw that arbitrage trading provides you a good profit by focusing on the value differences of an asset in multiple markets. However, you should take note of some potential risks as well.

  • Execution risk happens when you cannot close the arbitrage transaction within the stipulated time. If the price difference between two exchanges changes before you finish the transaction, it means you will face negative returns.
  • Liquidity risk is another problem, and it occurs when you cannot sell the crypto-asset in the second exchange as you planned to. If the markets do not move as smoothly as possible, you may have trouble buying and selling the assets.
  • Higher transaction fees can also turn the tables in arbitrage trading. As you may know, the crypto-assets industry uses dynamic transaction fees, and they can be so high sometimes. If these fees are higher than the profit you expect from the trade, it is a problem.

You have to keep these points in mind and act fast if you venture into arbitrage trading— even a fraction of second matters in this trading system.

Crypto Trading Bots

Grabbing crypto arbitrage opportunities by manually keeping an eye on the crypto markets is neither practical nor productive. That is where crypto trading bots can come in handy.

The primary objective of crypto trading bots is to help traders benefit from arbitrage opportunities by cashing in on price differences between two or more exchanges.

Bots can help traders increase profits and minimize risk by keeping losses across multiple exchanges in control.

For example, free crypto trading bots like Blackbird Bitcoin Arbitrage, Catalyst Enigma, and ZenBot enable traders to earn passive income using fully-automated trading strategies.

Some of the paid options include Shrimpy, Hassbot, 3Commas, and Cryptohopper. 

While arbitrage trading might imply “risk-free profit” or “guaranteed profit,” the reality is that there’s enough risk involved in keeping any trader on their toes. However, with the right amount of capital and practice to execute this strategy, you could be making a significant amount of profit with considerately low risk. 

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This content is not financial advice and it is not a recommendation to buy or sell any cryptocurrency or engage in any trading or other activities. You must not rely on this content for any financial decisions. Acquiring, trading, and otherwise transacting with cryptocurrency involves significant risks. We strongly advise our readers to conduct their own independent research before engaging in any such activities.

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