Arbitrage and Cryptocurrencies, What Is It And How Does It Work?

Arbitrage and Cryptocurrencies, What Is It And How Does It Work?
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The concept of cryptocurrency arbitrage refers to the strategy where an investor buys a cryptocurrency on one exchange and then quickly sells it on another exchange for a higher price.

The price of a cryptocurrency like Bitcoin may vary from one exchange to another, as cryptocurrencies like Bitcoin trade on hundreds of different exchanges around the world. In a situation like that, “arbitrage” is a common strategy that is also used by Wall Street experts. In the case of “capturing the arb,” it means taking advantage of the fact that one market can offer a bargain price for a particular asset, and another market can offer a higher price for that same asset.

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What Is Cryptocurrency Arbitrage?

The concept of crypto arbitrage is pretty straightforward. It is arbitrage where the asset in question is crypto. By using this strategy, you are able to profit from the fact that cryptocurrencies are priced differently from exchange to exchange. It is possible that Bitcoin might be priced at $19,000 on Coinbase, but it might cost $18,800 on Binance. Arbitrage can be considered to be the act of exploiting this difference in pricing. If the trader bought Bitcoin on Binance, transferred it to Coinbase, and sold it, the trader would earn around $200 profit.

Usually, these gaps are very short-lived since speed is the name of the game. In the event that the arbitrageur times the market correctly, however, can make enormous profits. Filecoin’s first appearance on exchanges was in early October of 2020 when some exchanges took the coins to $30 in the first few hours of its availability. But the price on other exchanges was $200.

How To Profit From Crypto Arbitrage?

Firstly, you must keep in mind that when engaging in crypto arbitrage, you are part of a very volatile market, and you have to keep that in mind when engaging in the transaction. Hence, if you are looking to make a profitable trade before the window of opportunity to do so closes, do nothing less than optimizing the speed of your trades.

By using exchanges with high liquidity, you will be able to optimize speed by matching and executing your orders as quickly as possible. Unlike trades handled by high-volume exchanges, low-volume exchanges may take several minutes to execute a trade. At that time, it would be too late to take advantage of arbitrage opportunities.

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Crypto arbitrage is possible when the top of the order books of two different markets are analyzed for opportunities, specifically the top of the order books in both markets.

The opportunity to utilize crypto arbitrage occurring when the best available bid on one exchange is higher than the best available ask on another exchange is known as crypto arbitrage.

It is important to note that whenever you are buying a cryptocurrency at market price, your buy order must match with the ask (sell) side of the order book. You sell a cryptocurrency at market price when your sell order matches the order book’s offer (buy) side in order to sell the cryptocurrency at the best price.

In a single market, it is impossible for a price to be higher than another unless the trades are matched up and completed at two or more exchanges – this is why basic arbitrage usually requires two or more exchanges.

In order to find a crypto arbitrage opportunity, traders will need to watch multiple markets for the same currency pair. When selecting the markets to pay attention to and the assets to invest in, there are a few things to keep in mind:

  • The asset to be chosen for investment should have multiple markets, whether they are on multiple exchanges or the same exchange with a different quote currency.
  • Make sure that you meet the eligibility requirements for signing up for and funding each exchange before watching two or more different ones at once. Arbitrage opportunities become meaningless if a trader does not have access to the exchange.
  • It is important to pick markets that have large order books to protect against price slippage – arbitrage trading involves buying at the market price and selling it at the market price, meaning you need to choose markets that have large order books.
  • It is possible to find arbitrage opportunities in cryptocurrencies that have high market capitalization as long as the above criteria are met. The most obvious choice for crypto arbitrage is Bitcoin and Ethereum. Both cryptocurrencies are widely used, have liquid markets on multiple exchanges, and frequently have high volatility.

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Types of arbitration

Arbitrage activities can be classified into several categories. In the following paragraphs, we will highlight the ones that are most popular among crypto traders:

Simple Arbitration

The simplest and most common type of arbitrage is this. In essence, it involves traders buying and selling the same digital asset simultaneously on two different exchanges in order to benefit from market inefficiencies on both exchanges. As it turns out, in this particular case, the trader identifies arbitraging opportunities on two specific exchanges, buys the assets on the platform where the price is lower, and sells them on the second exchange where the price is higher.

Statistical Arbitrage

The purpose of statistical arbitrage is to use quantitative data models to trade crypto and make a profit. Statistics arbitrage bots may trade hundreds of different cryptocurrencies simultaneously, using a mathematical model to carefully determine the probability that a particular bot will profit from the trade and then binary choose whether to go long or short on the trade.

In general, a bot will award low scores to a cryptocurrency that has performed exceptionally well and a high score to that which has performed particularly poorly, allowing for bigger profits to be earned from those who performed well. Trading algorithms that are worth their salt are those that have the capability of creating mathematical models capable of predicting the price of cryptocurrencies and that can expertly trade them against each other.

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Triangle Arbitration

There is a method for trading the difference between three different cryptocurrencies on a single exchange. This method involves the use of three different cryptocurrencies. This means that you do not have to worry about transfer fees since it is all done on one exchange.

An investor might look at arbitrage involving Bitcoin, Ethereum, and XRP as an opportunity for profit. Depending on which cryptocurrency you are looking for, it is likely that it is undervalued on the exchange. The trader might therefore take advantage of an arbitrage opportunity by selling their Bitcoin for Ethereum, then using Ethereum to buy XRP, which he or she would then use to buy Bitcoin back with the XRP that they have acquired. The trader would end up with more Bitcoin than they did at the beginning of their strategy if it made sense.

Automatic Arbitration

The idea of arbitrage may seem simple, but the fact of the matter is that this is nearly impossible to achieve manually. Because of these reasons, the majority of crypto arbitrage is performed by automated trading algorithms, also referred to as bots. By using these algorithms, data from multiple sources can be analyzed instantly.

Bots are able to monitor cryptocurrency prices 24 hours a day across multiple exchanges simultaneously and identify arbitrage opportunities and execute trades with speed and efficiency unmatched by any other trading platform.

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Defi Arbitrage

The traders who use this strategy are searching for decentralized exchanges (DEXs) that have arbitrage trading capabilities, such as Uniswap, Balancer, or Curve. Buying and selling pooled digital assets on these different platforms may be attempted by arbitragers whose digital assets may be undervalued or overvalued. This means that all DEXs eventually end up with the same price, just as it happens for centralized crypto exchanges.

There are a number of platforms where traders can convert stablecoins into stablecoins that will offer them a 10% yield, and another platform offers an 11% yield from a different stablecoin. A trader can use that 1% extra return to convert their low-yield stablecoin into a high-yield stablecoin. This process is automatic on many platforms. Yearn.finance transfers funds from one decentralized finance protocol to another to gain the best return on investment, for example.

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Is Crypto Arbitrage Profitable?

Certainly, cryptocurrency arbitrage has the potential to produce profits. There is always going to be a way for people to make money as long as there are price differences (which there are, of course).

It doesn’t mean that it will always be the right thing for you or that it is going to be easy for you. You should take into account the following factors before committing full effort.

There’s more to it than just the price differentials between exchanges, as we’ve seen already – the transaction fees are also important. There is no doubt that these might not be such a big deal for long-term or even short-term traders who hope to profit from the market by timing it, but anyone who is trying to make money through arbitrage is dealing with thin margins.

In addition, while arbitrage has a great sounding theory, on the ground, it is not always that easy – you never know if an exchange will suddenly freeze or shut down or if you will be caught out by technology and end up getting caught out. This is the reason it is so important to leave a margin of error when making a decision.

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Arbitrage, however, is a relatively safe form of trading compared to many other forms of trading. The likelihood of making a large profit is not always quite that high if you sell and buy the crypto at the same time on two different exchanges, but generally, you get away with only a small loss.

Is It Legal To Arbitrage With Cryptocurrencies?

It is fair to ask this question: is it legal to engage in arbitrage since it seems like a straightforward method to turn a profit, right? Crypto arbitrage trading is perfectly legal in most countries around the world, and it contributes to the efficiency of the market. 

As soon as an arbitrage trader has completed their trade, additional traders will inevitably come to the market who are trying to take advantage of the same price differential, thus leading to the asset’s price eventually becoming more balanced in all markets.

Nevertheless, some exceptions do exist. Prior to engaging in cryptocurrency or bitcoin arbitrage trading, you should familiarize yourself with your local laws

Advantages And Disadvantages Of Arbitration

In comparison to other trading strategies, cryptocurrencies arbitrage presents many advantages over other types of trading.

To begin with, arbitrage trading entails very little risk on the part of the trader. As a result of the fact that you aim to capture price variations between cryptocurrency exchanges simultaneously, you don’t have any open positions, and the risk associated with that is extremely low.

Furthermore, no matter how the prices change in the future, there is always a possibility of profiting from the difference in prices, as the price difference can occur both when the prices are decreasing and increasing.

As a consequence, you don’t have to wait for too long to reap the benefits of your investment. You will need very little time for the closing of your long and short positions if you have captured a positional arbitrage opportunity as price convergence happens quite fast.

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Also, it is important to note that arbitrage trading comes with several risks. The most common risk is slippage. In order for a trader to make significant profits, they have to make sure that the size of their order is not larger than the cheapest offer in the order book. If that order is too large, then it will ‘slip’ and cost them more than what they expected.

Another risk that is associated with arbitrage is the possibility of price movement. In order to take advantage of the spreads that are forming on the market, traders have to be quick to act as soon as they appear, as the spread could vanish in seconds. Trading bots have become popular in order to perform arbitrage trading. This has only increased the level of competition for traders.

Last but not least, traders must take into consideration the cost of transfers. It is important to remember that spreads and transaction fees are high for the major cryptocurrencies, which means that any potential profit could be wiped out by a transfer or transaction fee. Furthermore, because of these margins, traders who wish to achieve significant gains must execute a large number of trades to be able to reach their goals.

Conclusion

As long as you stick to the above basic crypto arbitrage best practices and measures, you should be able to maximize your profit from the multiple arbitrage opportunities that are available today in the crypto market.

There are several cryptocurrencies and exchanges, and there are lots of arbitrage opportunities, and these opportunities last for a very short period of time. Therefore, an automated bot is often required to monitor and harvest these opportunities.

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