Trading cryptocurrencies is more than buying or selling assets at the right time. Some traders never hold investments for more than a few seconds, yet they are not day trading. Instead, they opt for arbitrage trading, a less risky strategy but one that requires a bit more work.
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The Idea Behind Arbitrage Trading
Compared to regular buying, selling, and flipping crypto-assets, arbitrage trading is widely considered to incur less risk. It does not require holding onto assets for long. Instead, a trader will actively seek out price differences for specific assets between different exchanges and trading platforms.
Bitcoin is often a good example, as its value is rarely the same across all platforms. Even a $20 price difference can be worth exploring, although these price gaps usually don’t last that long. Timing is of the essence when chasing down arbitrage opportunities.
Taking advantage of these price gaps is a common strategy among cryptocurrency enthusiasts. While no one will earn thousands of dollars per day, small earnings can still add up nicely. As more exchanges come to market, there will eventually be more arbitrage trading opportunities.
A Guarantee For Profit (Sort Of)
On paper, an arbitrage trading opportunity will always net a profit. If Bitcoin trades for $40,000 on Bitstamp and has a price of $40,120 on Binance, it is a no-brainer. Buying what one can on Bitstamp, moving the funds to Binance, and sell it there for a higher price will always net a profit.
However, exploiting these price gaps is not that easy. Bitcoin is one of the slowest assets to move between exchanges. By the time it arrives on Binance as a deposit, the price gap may be gone, or the market may have turned bearish. Finding liquid assets that require less than 10 minutes to confirm as a deposit is often preferable.
Some people may claim arbitrage trading is a guaranteed profit. That is somewhat correct, albeit there are no guarantees in the cryptocurrency world. A lot of traders look for these opportunities, and it is a first-come, first-serve scenario. Time is of the essence, and things may not always unfold in your favor.
How Arbitrage Trading Works
The concept of buying an asset in one market and selling it in the other is not difficult to understand. Unfortunately, the cryptocurrency industry is a bit fractured. There are hundreds of trading platforms requiring funds to move on the network as regular transactions. For Bitcoin, this can cause transfers to take up to an hour, nullifying any arbitrage gap.
Having the ability to capitalize on price gaps quickly is crucial. You can do arbitrage trading manually, but it is often better to rely on external tools. Several trading bots and algorithms allow users to explore price gaps across different markets actively. However, those solutions usually cost money, and exploring arbitrage gaps isn’t the most profitable option. Even then, it is still an excellent way to learn a bit more about cryptocurrency markets.
Different Types To Explore
Similar to using regular trading strategies, different ways of experimenting with arbitrage trading exist as well. Finding the option that suits your need best is crucial. Moreover, you can combine these methods into a more aggressive strategy if that is preferred.
Exchange Arbitrage Trading
The most common option is to explore arbitrage trading opportunities between exchanges and trading platforms. As mentioned before, the price f crypto-assets between different platforms can vary slightly, assuming enough liquidity exists.
Such small profit opportunities are worth exploring, although it requires having accounts on dozens of trading platforms – and verifying one’s identity across all of them. Once those accounts are set up, they can be sued for the trading platform’s lifetime, though. Preparing adequately is advised, as more exchanges to compare prices from will lead to more arbitrage gaps.
Funding Rate Arbitrage Trading
Although a bit more advanced, the funding rate arbitrage can be a lucrative option. It revolves around owning a specific asset and hedging against its price changes, with a futures contract for that asset. Using this method requires a vast knowledge of derivatives trading and the platforms providing this functionality.
This method only works if the futures contract’s funding rate is lower than the cost of purchasing the crypto-asset itself.
Assuming one owns Bitcoin, it can be worthwhile to sell a futures contract for BTC at the same value as your current BTC holdings. If the futures contract pays you 1.5% or more, you are effectively earning money without taking any real risks.
Triangular Arbitrage Trading
The last method on the list can prove to be relatively successful. A user will exchange three different crypto-assets between different exchanges to maximize their profits in a triangular arbitrage setup.
Using the triangular arbitrage method often involves fiat currencies, either to obtain the initial asset or to sell the final asset. As such, users may end up holding fiat currencies not native to their country or region. Whether that is a downside or an upside is a matter of personal preference.
For example, you buy BTC with USD on Exchange A, convert that BTH to ETH on exchange B, and sell ETH for Indian Rupees (INR) on exchange C. You can then buy back any other asset with INR and start the cycle anew.
Don’t Ignore Trading Fees
When exploring price gaps between different exchanges and trading platforms, it is crucial to pay attention to trading fees. Every company has its cost requirement that will eat into your profit. Subtracting these fees from one’s potential profit can often erode the appeal of some arbitrage trading opportunities.
Mainly when using triangular arbitrage, there are six fees to be paid. All exchanges have a maker and a taker fee. As this method involves three platforms, those fees can add up quickly. Calculating the risk/reward/fee correlation will prove mandatory when going down this route.
A Few Risks To Consider
Engaging in arbitrage trading may carry low risk, but it is not without potential issues. Two common risks exist: execution risk and liquidity risk.
The execution risk pertains to any price gaps closing before you can execute the final trade. Chances of this happening are high, mainly when relying on three trading platforms. Achieving zero or negative returns is a very tangible outcome, which is far from ideal.
For liquidity risk, it mainly affects smaller exchanges and trading platforms. After going through the motions to set up a trade, there may not be sufficient liquidity to get out of the market without a small loss. Analyzing the involved trading platforms can often help avoid liquidity risk altogether.
Exploring arbitrage trading in the cryptocurrency industry – or other markets – can be a low-risk option to score a quick profit. However, it is a method that requires a lot of research, timing, and effort. It may not be ideal for everyone, and there is no guarantee you’ll make a profit either.
Additionally, after deducting all trading fees, one has to wonder if the money earned is worth the overall effort. If you can make more money doing something entirely different, arbitrage trading is not the best option.
It is a fun way of exploiting markets but not necessarily the best way to earn money with cryptocurrencies.