Crypto Arbitrage Trading: What Is It and How Does It Work?

Investing in cryptocurrency arbitrage means profiting from variations in price between various exchanges. Traders or, more frequently, computer trading bots, keep an eye on cryptocurrency values across many exchanges and geographical areas, looking for instances where the same coin is priced differently. 

When traders spot a price disparity like this, they act quickly to seize the opportunity. Because of the way exchanges set the price of cryptocurrency pairs, arbitrage trading is feasible. On the majority of exchanges, prices are often found through an order book that contains buy and sell orders for particular cryptocurrency assets. 

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As previously said, crypto arbitrage trading involves identifying price disparities between several exchanges. An arbitrage trade may be possible if there are disparate prices for a certain cryptocurrency asset.

Wide-margin arbitrage opportunities are not common, but they do occur.

Different Types of Arbitrage to Know

Source: Quantinsti

• Over 18,000 cryptocurrencies are in use as of 2022.
• Traditional financial markets: 2014 – about 500 distinct cryptocurrencies.
• Retail traders compete in the cryptocurrency market. Some funds own Bitcoin and Ethereum.
• Hundreds or even thousands of altcoins are accessible on exchanges.
• Trade duration: minutes, reducing price fluctuation risk.
• Institutional entities use trading bots.
• Institutional entities dominate traditional markets. Retail investors face competition from institutions.
• Upon its release on exchanges in October 2020, Filecoin was listed for approximately US$ on a few of them. In other markets, the price shot up to more than $200.

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Trade between Exchanges (Simple Arbitrage)

One is a cross-exchange trade, which is simply referred to as simple arbitrage. This is the process of purchasing a cryptocurrency on one exchange, transferring it to another, and selling it there for a profit.

The drawback of this approach is that it may take several minutes, if not more, to move between exchangers. During this time, an arbitrage opportunity could vanish or there could be slippage, a situation in which the token’s price changes before you can complete your trade. 

Keeping the Same Asset on Various Exchanges

Keeping the same digital asset open on two separate exchanges at the same time is another way to engage in crypto arbitrage. After that, you would purchase a token on one exchange and sell it on another almost simultaneously to complete an arbitrage trade. The only drawback is that purchasing cryptocurrency on both exchanges requires you to have sufficient starting capital on hand, which means you’ll need to make a larger upfront investment. 

Triangular Arbitrage

Triangular arbitrage, as the name implies, is the practice of taking advantage of brief price differentials between three paired cryptocurrencies on different exchanges.

Take into account, for instance, the following exchange rates for Dogecoin (DOGE), Litecoin (LTC), and Bitcoin (BTC):

One Bitcoin is equal to 400 LTC; one LTC is equal to 0.05 DOGE and one DOGE is equal to 0.02 BTC.

Triangle arbitrage can be carried out by making use of these rates. At first, 400 LTC are obtained by converting 1 BTC to LTC. Then, 8 DOGE are obtained by exchanging the 400 LTC for DOGE. Lastly, the benefit from triangular arbitrage, which is generated by selling the 8 DOGE for BTC, is 0.16 BTC.

Benefits of Cryptocurrency Arbitrage

Utilizing cryptocurrency arbitrage as a trading method has a few noteworthy benefits: 

Source: Investopedia

Significantly Reduced Investment Horizon

Cryptocurrency arbitrage has the potential to yield profits in a short amount of time since it allows you to purchase at one exchange and sell at another in a matter of minutes. This is not the case for swing trading or other technical trading strategies, which demand far bigger capital commitments. 

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Diversity of Opportunity

Numerous cryptocurrency exchanges exist, with the majority providing traders with access to hundreds or even thousands of various altcoins. This implies that there are a lot of chances to locate arbitrage possibilities that people might have overlooked. It’s also important to note how swiftly the cryptocurrency market is expanding. There were about 500 distinct cryptocurrencies in 2014. There are currently more than 18,000 in use as of 2022. Even with Bitcoin’s rise in popularity, very few people invest in cryptocurrencies. This implies that there is a lot of room for expansion in terms of new coin development and, consequently, arbitrage opportunities.

Lower Risk

That implies there is a lot less danger involved, considering how fast money enters and exits any given arbitrage trade. If there are no delays in your transactions, a trade that lasts only a few minutes reduces the amount of room for price fluctuations, even in erratic cryptocurrency marketplaces. 

Conclusion

For the average retail investor, arbitrage trading in traditional financial markets is nearly impossible. Too many hedge funds and other institutional entities currently use sophisticated trading bots driven by artificial intelligence that can quickly identify and take advantage of arbitrage possibilities.

However, fewer institutional investors are making small investments in the cryptocurrency space. While some funds dabble in owning Bitcoin and Ethereum, the majority of other cryptocurrencies are largely unexplored. Retail traders are the only rivals in the cryptocurrency market; their trading bots are either less sophisticated than those of institutional investors, or they trade in considerably smaller volumes. 

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