Crypto Arbitrage- What You Need to Know to Profit

Business woman pulling a trolley

Are you ready to take advantage of the constant price movement in the cryptocurrency space? If you are ready to take your crypto investing to another level, then arbitrage will probably seem like an attractive prospect.

When done successfully crypto arbitrage can mean making money simply by moving from one exchange to another. However, when done wrong it could mean losing huge sums. Therefore, ensure you know what you are doing before you attempt crypto arbitrage trading.

What is crypto arbitrage?

Crypto arbitrage is a type of trading strategy where investors capitalize on minute price differences of the digital assets across multiple markets or exchanges. In a simple form, arbitrage trading means buying a digital asset on one exchange and selling it almost simultaneously on another where the price is a bit higher. Doing this means making a profit through a process that involves little or no risk. The other great upside of this strategy is that you don’t need to be a professional investor or have an MBA or an ivy-League degree before you can begin arbitrage trading.

Arbitrage trading has been in existence in the traditional financial market long before the emergence of the crypto-currency market. However, there seems to be more hype surrounding the potential of arbitrage opportunities in the crypto environment. Why is this the case? One reason is that the crypto market is notorious for being highly volatile compared to other financial markets. This means crypto-assets tend to fluctuate in value significantly within a short period of time.

As crypto assets are traded globally across multiple exchanges all day long and all-year-round there are far more opportunities for traders to find arbitrage opportunities where there is a difference in price more than the normal traditional market which closes by the weekend, and on public holidays.

All a trader needs to do is to spot a difference in the pricing of digital assets across two or more exchanges and then execute a series of transactions to take advantage of the difference. Let’s assume you buy bitcoin at $42,000 on Binance and you notice that the price on Kraken is $43,000. In this scenario, arbitrageurs might spot this disparity and buy bitcoin on Binance and sell it on Kraken. This is a typical example of crypto arbitrage trade. Also, note that in the crypto-currency market a few large exchanges dictate the price and the smaller exchanges follow suit slowly.

Portions of the pie
Portions of the pie

Types of arbitrage

Did you know that there are a few different types of crypto arbitrage, all of which work differently? Yes, you heard it right. Just as you thought you knew it all, you didn’t.

Spatial arbitrage is a type of habit right that involves purchasing crypto from One exchange and immediately selling it for another at a higher price.

Convergence arbitrage in this scenario a coin is bought on one exchange and sold short on another exchange period the goal here is to see both prices converge and that is when the arbitrageur closes both positions.

Triangular arbitrage: This is the most complicated strategy; it involves trading across more than one trading pair.

Why do crypto exchange prices differ?

Liquidity- every exchange has a different amount of liquidity for assets. Depending on the number of people buying and selling an asset this varies between exchanges resulting in different prices the more liquid an exchange is the lower the price the more liquidity is limited the price tends to go higher.

Different exchange types. Not every exchange is the same many of them target different types of investors target different locations and different countries different markets and this can affect prices.

Withdrawal and deposit times. Exchanges that have slow processing times take longer to catch up with the overall market rate. Oftentimes these are the smaller exchanges.

Foreign exchange rate to even make more profit a smart arbitrage can buy crypto in one exchange in one currency and sell in another this allows you to secure profit if it is relatively cheaper in one currency.

Centralized exchanges

Mispricing of assets on centralized exchanges depends on the most recent bid-ask might order on the exchange order book. The most recent price at which a trader makes a buying request and the most recent price that a seller is willing to sell is considered the real-time price of that asset on the exchange. Take for instance if there is another to buy bitcoin for $60,000 and that’s the most recent matched order on the next change automatically $60,000 becomes the latest price for bitcoin on that platform the next order will be fulfilled based on the price to be matched based on the seller and buyer price that are available which is known as the spread.

As a result of this, price discovery on an exchange is a continuous process of simulating the price of digital assets based on the most recent selling price. Prices also vary because investor demand for assets is different on each exchange.

Decentralized exchanges

On the other hand, decentralized exchanges use a different method for pricing crypto assets. This is known as an automated market maker system. It relies on crypto arbitrage traders to keep the price consistent with those in other exchanges. There is no order book in this method of exchange. What they do is rely on liquidity pools. So, for each trading pair, a separate liquidity pool is created. For instance, if a person wants to buy BTC for ETH, they will need to locate BTC/ETH liquidity pool on the exchange.

Each liquidity pool is funded by individual contributors who deposit their own crypto assets to provide liquidity which others are able to trade in exchange for a share of the transaction fees. So, they make their profit from a share of the transaction fees charged by the exchange. The main goal of this system is that traders do not have to wait for a counterparty before they can buy or sell assets. As such, they can execute trades at any given time.

Forex Trader on video call
Forex Trader on video call

Why crypto arbitrage is considered low risk

Unlike day traders, arbitrage traders do not have to predict the future of the prices of Bitcoin or enter trades that could take days before they can make a profit. By simply spotting arbitrage opportunities and taking advantage of them, traders base their decision on an expectation of generating profit without having to analyze market sentiment. Furthermore, they don’t need to rely on emotions to succeed in their trades.

Again, depending on available resources it is possible to enter and exit an obituary arbitrage trade in a short time.

In summary, the risk involved in arbitrage trading is considerably lower than many other trading strategies because traders do not need to predict the future price. Also, arbitrage traders only have to execute trades that last maximum of 4 minutes. Exposure to trading risk is significantly reduced. This does not mean that there are no risks at all it only means that the risks are significantly reduced.

Factors that could affect profit in arbitrage trading

There are some factors that could affect the arbitrage traders’ chances of making a profit. One of them is fees. Keep in mind that when making transactions fees accompany trading. Moving funds across two exchanges is likely to incur withdrawal and deposit and trading fees. So, the fees accumulate and eat into your profit. As such, you need to do your calculations properly and ensure you are in profit after deducting fees.

Again, as an arbitrage trader, you can limit your activity to those exchanges which have competitive fees. This reduces your risk exposure.

Disclosure

This article isn’t financial advice. Please do your own research before making any investments.

Abiodun Ajayi has more than 6 years of experience in Security and IT architecture. He consults and helps form strategies, perform project feasibility studies.