The cryptocurrency market is marked by volatility, which deters no coiners the most. However, one may argue that it’s a blessing in disguise. Crypto traders can capitalize on the rapid changes in prices across different platforms. One way they do this is through "Crypto Arbitrage."
What is crypto arbitrage? How do I go about it? Are there any risks to arbitrage trading? Come with us as we explain the concept of crypto arbitrage in detail.
Understanding Crypto Arbitrage
Imagine buying a basket of oranges for $30 in Market A. Then, you go into Market B and sell it to another person for $32. That's a profit of $2. That’s the principle by which crypto arbitrage works.
In crypto arbitrage trading, however, you are not dealing with oranges. Here, you exploit price differences for the same cryptocurrency across various exchanges.
Defining the term, crypto arbitrage is a trading strategy that involves simultaneously buying and selling the same cryptocurrency on different exchanges to profit from price differences.
The Principle of Crypto Arbitrage
You might be wondering why there is a price difference across exchanges. Why is the price of BTC on Binance different from that on Coinbase? Are they not regulated? These are all valid questions.
Arbitrage is based on the principle of inefficient markets. A token may trade cheaper on one exchange and more expensive on another. These price discrepancies arise from several factors:
- Decentralization (no centralization) means there is no regulator controlling prices. Exchanges operate independently, leading to price variations.
- The crypto market is fragmented. Each exchange has its liquidity pool, user base, and order book. This results in price differences.
- Liquidity and trading volume: Exchanges with lower liquidity and trading volume may have different prices due to reduced market activity.
How Does Crypto Arbitrage Trading Work?
Now that you know the principles behind arbitrage trading, it's time to see how to go about it. Here are the different steps of implementing an arbitrage trade:
- Market Monitoring: The first stage involves studying the market for price differences. There are two ways to do this: manually or using monitoring software. The latter is easier and faster, as a bot helps you find price discrepancies. These tools may come with subscription fees.
- Spot Openings: At this point, you must have experienced a price discrepancy on the crypto you want to trade in arbitrage. But before going with the transaction, you have to ensure the profit in price difference is worth it. So, consider the transaction fees and time to prevent it from eating out of your profit.
- Crypto Purchase: After calculating the likelihood of profit, you can buy the crypto (at a lower price). Be sure to keep an eye on the market's liquidity when placing your buy orders. You want to buy the required amount of tokens without triggering a price movement.
- Funds Transfer: The purchased tokens must be listed on the exchange where you plan to sell them at a higher price. You must also be quick about this, as any delay could lead to a price change. If the price happens to go lower, you will end up at a loss and a missed arbitrage opportunity.
- Crypto Sale: This is the final stage. Here, the transferred tokens are sold at a higher price. Once done, it's advisable to withdraw your profits before further price movements.
Now you see how crypto arbitrage works. In summary, the basis of the operations is price differences and speed. Once you notice an opportunity such as an arbitrage trade, you have to act fast to ensure maximum gains.
Types of Crypto Arbitrage
There are various ways traders can approach crypto arbitrage opportunities. However, we can broadly classify them into cross-platform and intra-exchange. Cross-platform is most common, and we’ve already hinted at it above.
In this section, however, we will further explain cross-platform arbitrage and provide insights into how intra-exchange arbitrage works. Without further ado, let's get into dissecting!
Cross-platform arbitrage
As stated earlier, it involves making a profit by capitalizing on price differences of a particular token between two exchanges. Cross-platform arbitrage is further subdivided into three categories.
- Standard Arbitrage
This form of cross-platform arbitrage involves taking advantage of short-term price mismatches between two CeFi platforms. These market inefficiencies do not last long, occurring in seconds or minutes. Therefore, traders must quickly take advantage of this to make a profit.
An example is the price of LTC, which is slightly different on Crypto.com and Kraken. On Crypto.com, the LTC price is $65; on Kraken, it is $65.65. Standard arbitrage would see a trader purchasing a huge sum on Crypto.com and then selling it for a profit on Kraken.
- Spatial Arbitrage
Spatial arbitrage involves arbitrage between two platforms in different jurisdictions. A typical example is The Kimchi premium in South Korea. Here, exchanges in South Korea would have notable price differences from trading platforms around the globe.
In July 2023, a notable spatial arbitrage opportunity emerged on Curve Finance (CRV). The price discrepancy arose following an exploit targeting the DeFi protocol's liquidity pools. It resulted in CRV trading at a substantial premium of up to 600% on Bithumb and 55% on Upbit.
- Decentralized Arbitrage
This is a specialized form of cross-exchange trading. Rather than order books, DeFi platforms use Automated Market Makers (AMMs). This means that decentralized exchanges operate based on market demands.
The difference in structure often leads to price differences between DeFi platforms and Centralized exchanges. That said, traders can capitalize on this by buying a crypto on a DEX and selling it on a CEX, or vice versa.
Intra-Exchange Arbitrage
From the name, you can tell it takes place within just one exchange. This type of trading occurs when there is a price discrepancy between different trading pairs. For example, BTC/USDC and DOGE/USDC. There are two major subdivisions of intra-exchange arbitrage.
- Funding Fee Futures/Spot Arbitrage
Every trader should be familiar with spot trading. However, only experts are expected to know about "Futures."
For those who don't know, futures are contracts involving bets on a cryptocurrency's future price. Futures trading is a common practice on CEXs. The platforms allow traders to leverage positions and speculate on the future price of crypto assets.
Traders can choose to go long (anticipate a price increase) or short (anticipate a price decrease). When more traders are longing than shorting, long traders pay the funding rate fee to short traders, and vice versa. What, then, is the funding fee? In short, it is the periodic payment between long and short positions in perpetual futures contracts.
The funding fee mechanism allows for funding rate arbitrage, where traders can hedge their futures by taking opposite positions in the spot market. By doing so, they can profit from the funding rate differential minus trading fees, making it a significant strategy in crypto futures trading.
- Peer-to-peer (P2P) Arbitrage
Although P2P arbitrage could occur on cross-platforms, it's more dominant on the same exchange. Here, traders take advantage of price differences between P2P merchants on the same platform. The trader buys a cryptocurrency at a lower price from a merchant and then sells it at a higher price to another merchant.
Also, it doesn't necessarily have to be from merchant to merchant; it could be a price difference between what’s on the exchange and merchants in the P2P section. Suppose that you find Ethereum is $2,400 on the spot market. However, you spot an opportunity to sell the token at $2,520 in the P2P market. Then, you can quickly buy ETH and directly sell it on the P2P market.
The basic mechanics of crypto P2P arbitrage work like this:
- Identify a cryptocurrency with the widest bid-ask spread.
- Become a merchant, then post buy/sell ads for the crypto and wait for counterparties.
- Buy low, sell high with minimal effort.
How to find arbitrage opportunities in crypto?
Under the "How Does Crypto Arbitrage Trading Work?" section, one of our points was spotting openings. In this section, we will shed more light on that aspect. Below are four practical ways of spotting price discrepancies in the market.
Manual Research
This approach would depend on the type of crypto arbitrage trading you are into, cross-platform or intra-exchange.
For cross-platform, you are required to thoroughly research and identify exchanges where the same assets are traded at different prices. Tools like CoinMarketCap or CryptoCompare are helpful for comparison. Intra-exchange, on the other hand, is easier. All you have to do is review the trading pairs and find out which is more suitable for gains.
You should also consider liquidity levels, trading volumes, and geographical locations in your research.
Arbitrage Bots
One downside to manual research is that it’s time-intensive. Searching for price differences could take time, and the window of opportunity is usually short. By the time you notice the possible arbitrage, it might be too late to act on it. Thankfully, as usual, technology came to the rescue, and arbitrage trading bots were born.
Bots can be programmed to detect price gaps and sometimes act on them by executing the trade. Although they save you time, they attract a subscription fee. Think of it as gas to fuel bot operations. Examples of arbitrage bots are ArbiTool and CryptoHopper.
Social Media and Forums
Most crypto traders are active on social media platforms, with many creating communities. The most common apps for crypto enthusiasts include Telegram, Discord, Reddit, and X (formerly Twitter). These platforms are filled with information, some of which is legit and most of which are speculations. Therefore, you have to review them thoroughly.
The bright side of this is the availability of forums or group chats. For example, traders on a forum like Reddit's r/CryptoCurrency can provide updates on price discrepancies between Ethereum on Kraken and Bittrex. The more people on the forum or group chat, the more updates. Hanging around online communities is a great way to find arbitrage opportunities.
APIs and Scripting
An Application Programming Interface (API) is a set of protocols that allow different software to communicate with each other. What does this have to do with crypto arbitrage trading? Well, these APIs can be configured for exchanges using custom scripts. These scripts automatically monitor price gaps.
For example, if you notice XRP is usually cheaper on Bitstamp than on Binance, you can configure an API. Your script will be written to notify you of the price changes. Also, the script could make automated transactions. Due to the short time frame, it's best to allow the API to buy XRP on Bitstamp and sell it on Binance.
Risks and Challenges in Crypto Arbitrage
Crypto arbitrage is considered a low-risk trading strategy. Low risk doesn't mean it is risk-free. The following factors can pose challenges during crypto arbitrage trading.
- Volatility: Once again, crypto tokens are highly volatile. Price movements occur rapidly, meaning you have to be fast when trading arbitrage. A negative swing in price would result in a loss of funds. Volatility is a double-edged sword. It brings both opportunities and challenges.
- Lower returns: Because it is low-risk, the returns are usually lower than those of other forms of trading. You have to invest a huge sum of money to make a sizable profit. If the window closes, the trader fails to make a profit.
- Regulations: Although cryptocurrencies have been around for a while, regulation is still a concern. There is a significant risk when using the cross-exchange strategy across separate jurisdictions. Any slight hiccup from the authorities could result in a loss of funds. It's advisable to be familiar with the laws of jurisdictions before creating an account.
- Account setup: To become a top arbitrage trader, you have to set up a lot of accounts. This includes accounts with different exchanges or bot services. Also, for first-hand information, you have to be active on various social platforms. Managing these accounts could be strenuous.
- Time-consuming: Whether you conduct manual research or use a bot, crypto arbitrage requires your time. The crypto market operates 24/7, meaning an arbitrage opportunity could occur at any moment. The challenge is spending hours looking for the right and most profitable trade, which can be draining.
- Potential Delays: Most times, arbitrage occurs between two platforms. Any delay could see you miss your window of opportunity. In a scenario where there is an issue with the processing times for deposits and withdrawals, traders are likely to incur losses.
- Fees: Trading on crypto platforms isn't free. These platforms charge various platform fees. That's not all; transacting with some cryptocurrencies comes with hefty fees. An example is ERC-20 tokens requiring high gas fees. Putting together these fees will minimize the profit margin.
Advanced Crypto Arbitrage Strategies
The two strategies mentioned earlier are the basic principles for crypto arbitrage trading. They are best used by beginners, while professionals use them as templates for more advanced strategies. In this section, we shall be reviewing two of the most advanced crypto arbitrage strategies.
Before we go into them, note that these strategies require expert knowledge and risk management. Beginners are advised to stay clear of these strategies.
Triangle Arbitrage
Triangular arbitrage involves exploiting price discrepancies in the market between three different cryptocurrencies on the same or different exchanges. With several factors in play, it requires precise calculations and swift execution. An arbitrage bot can simplify the process.
There are different ways to execute triangle arbitrage trading. The common ways are placing a buy-buy-sell order or a buy-sell-sell order. Let's take the latter as an example. Here, you buy BTC with ETH (Exchange A), sell BTC for USDT (Exchange B), and finally, you sell USDT for ETH (Exchange C).
Statistical Arbitrage
Statistical arbitrage (stat arb) is one of the most complex trading strategies out there. It leverages statistical and computational methods to identify and exploit price differences. Unlike traditional crypto arbitrage strategies, stat arb involves predicting and capitalizing on price movements over a time period.
It is predicated on the idea that previous pricing correlations between assets will likely persist. Traders employ statistical models to evaluate historical price data for multiple cryptocurrencies. They look for patterns and correlations that diverge from normal price behaviour. However, this doesn't guarantee a successful trade.
Conclusion: Is Crypto Arbitrage Right for You?
From our guide, you probably should know your stance by now. Crypto arbitrage serves as a low-risk trading strategy, making it one of the safest ways to earn a little cash. Although it is low-risk, there are still risks. To become a successful trader, you must have proper risk management principles, which will help you find a suitable risk-reward balance. Lastly, it's advisable to conduct personal research or seek the help of a professional before trading.
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