What Is Arbitrage Trading and Why It Matters in the Crypto Market?
Arbitrage in finance is a trade that involves two different markets where a single type of asset is being traded. The price difference between different markets is the profit that a smart investor pockets by simultaneously buying an asset in one market and selling in another. This approach is all about looking for opportunities for profit and trying to minimize risk.
The information is key for an arbitrage trader. Many famous merchants of the past made fortunes by carefully examining prices on different trading outposts. For example, some merchants used a network of spies and associates along the Great Silk Road to assess prices quicker than their competitors. They would make purchases while selling the same stock of goods on different outposts to make money on the price difference.
One of the biggest disadvantages and risks of this strategy is price convergence. As information travels across markets, participants of the economy quickly adjust prices making it harder for traders to make money. In the digital era, we have the internet and instant communication making convergence risks even more evident. However, with enough dedication and the power of automation, you can still make arbitrage work!
Arbitrage trading in crypto is still possible since many centralized exchanges are situated in different parts of the world. It means that people are active throughout the 24-hour cycle allowing you to find good moments to perform a crypto arbitrage trade. While it is quite hard to find such opportunities due to fast price convergence, you may bypass this issue by running multiple bots trading different types of assets at all times.
The cryptocurrency market is diverse and offers a wide range of interesting possibilities to all retail traders. Arbitrage is definitely a great approach to trading that should be considered by everyone. The technology made this strategy less efficient, but it is still one of the safest ways to trade digital assets without risking too much. Remember that the world of blockchain created a decentralized market where you can have multiple marketplaces working independently from each other, any central authority, or congregation of traders.
How to arbitrage cryptocurrency
The strategy did not change that much since it was conceived centuries ago. It still requires an investor to do the following:
- Identify interesting assets that are traded with enough volume and liquidity to warrant price differences on multiple simultaneously working marketplaces.
- Start monitoring prices in real-time to find moments when the price diverges to a significant degree allowing you to make profit.
- Sell high on one platform while buying low on another platform. The trade must be mirrored to fulfill the requirements of an arbitrage trade.
- Rinse and repeat.
You may also be interested in using a more advanced version of the strategy called “Triangular Arbitrage”. You will need to find three different pairs of assets sharing base assets. If you want to learn how to arbitrage Bitcoin, this approach is certainly something that you need to learn since there will be more opportunities for triangular arbitrage during periods of volatility.
Bitcoin arbitrage trading using the triangular approach looks like this:
- Pick three pairs with shared assets (e.g. BTC/ETH, ETH/USDT, BTC/USDT).
- Look for moments when the price between BTC/ETH and BTC/USDT diverge from ETH/USDT.
- If ETH goes up against USDT, sell BTC for ETH and buy BTC for USDT.
- If ETH goes down against USDT, sell BTC for USDT and buy BTC for ETH.
Using USDT as the main exchange medium, you can quickly find moments when it is beneficial to engage in triangular arbitrage crypto trading while bypassing the need to conduct more operations than needed to receive the profit denoted in BTC. Note that you will need sizeable portfolio with all three assets in sufficient quantity to make profit using this method.
On the other hand, you may simply switch to working on a centralized exchange and use leverage to increase the profits. While using leverage is quite risky when working with derivatives or trading cryptocurrencies in a traditional way, arbitrage is a much safer method but it requires bigger leverage or more initial capital to work as intended.
How Does Arbitrage Trading Work in Cryptocurrency?
The cryptocurrency market is quite complicated and has thousands of different digital assets to choose from when it comes to engaging in arbitrage. The market operates around the clock and many platforms exchange information. It means that price convergence occurs rapidly even after relatively large trades that cause price differences. It takes minutes and even less for all market participants to adjust prices according to the circumstances.
However, arbitrage is still widely used by thousands of retail traders working in the crypto industry. How is that even possible? The crypto industry has several important qualities that allow arbitrage strategy users to benefit from price differences across exchanges:
- All centralized platforms have APIs. Application Programming Interface is a gateway through which two different digital platforms can communicate without using the user interface. It means that all CEX companies allow their clients to use third-party service providers to connect to their platform and place orders instantly. Trading bots use this particular feature to quickly react to trading signals and place orders on exchanges.
- There are thousands of cryptocurrencies. Different layer-2 tokens issued by DeFi platforms, non-fungible tokens (NFTs), layer-1 tokens like BTC, DOGE, ETH, and other forms of digital assets create a diverse financial ecosystem where smart investors regularly find unique opportunities to make money. With so many assets being tossed around, you will always stumble upon an arbitrage deal that will be profitable!
- Transactions on CEX platforms are instant. You can use DEX platforms to arbitrage, but the processing times and other technological bottlenecks may create unforeseen problems. Prices also change slower on decentralized platforms since many are just spot markets where people actually swap tokens instead of trying to make a quick buck. Centralized cryptocurrency exchanges that take your money into custody will execute orders instantly allowing for faster arbitrage and bigger profits.
The Risks and Challenges of Crypto Arbitrage Trading
Let’s summarize some of the challenges with arbitrage trading that we’ve already outlined previously. The biggest advantage of arbitrage is that it is riskless on paper meaning that every deal that you conduct should, theoretically, end up profitable. It is true, but some factors may affect the overall performance of the strategy and average earnings.
- Commissions. Some centralized exchanges have flexible commissions or use dynamic fee systems. It means that you need to calculate potential profits for every deal before actually committing. Since price convergence happens so quickly in the cryptocurrency market, any delay can be detrimental. For DEX platforms, you also must remember about network transaction fees and delays.
- Late delivery. When dealing with decentralized exchanges, you will often have your funds locked in escrow. Ordered assets may arrive with a significant delay. A deal may even be cancelled by another party. Even the transaction speed can be a big issue. The slow pace of the process will leave you without available funds for trading.
- Price convergence speed. Assessing prices manually can be extremely inefficient. While you are looking at prices on one platform, they can change on another. It is quite challenging to stay up to date with the pace of change. Again, automation is the only feasible way to keep up.
- Small margins. Any investment opportunity that promises low risks will be associated with lower returns. Arbitrage is an extremely safe trade but it comes with the downside of very low returns. It means that you need to make dozens of trades to turn a profit.
- Security risks arise when it comes to working with different centralized exchanges. Some of them can be untrustworthy or conduct unlawful operations. Another issue is when one of the exchanges cannot finalize a trade due to liquidity issues, technical problems, and other factors. These are known issues.
- Market volatility. This particular issue does not affect arbitrage in the same way it does regular long and short positions. Market volatility can become a problem when you need to finish a trade at very specific prices, but they change dramatically due to unforeseen forces.
These issues are not easy to overcome and should be considered before you start running a massive arbitrage operation. Note that some of these problems can be mitigated by running bots. It is possible to have hundreds of robots monitoring a wide range of different assets. If these automated systems notice an opportunity, they act immediately.
The Benefits of Investing in Cryptocurrency through Arbitrage Trading
It is hard to expect this strategy to have a potential for high returns on investments due to low return per trade. This particular issue can be offset by using multiple bots each making a trade only when opportunities are perfect for a risk-free transaction. You will need to scale up this operation to ensure that you make money consistently, but it will take time and effort.
The low-return issue is the biggest problem that many investors believe to be the reason why they stay away from using arbitrage. It takes knowledge, dedication, and some capital to make the strategy work. These difficulties are intimidating and may scare some newcomers, but you need to consider some very important benefits.
- Riskless setups. It is possible to make a strategy with a very low risk with proper strategy and execution. Using automation, advanced technical analysis tricks, and other tools in your arsenal can dramatically reduce the exposure of your portfolio to risks.
- You can diversify with arbitrage. Having an army of bots that waits for a perfect moment to act is like hedging against your other risker endeavors. You may dedicate a certain portion of your portfolio to these safe bots and collect profits as they come.
- Effortless scalability. Once you have a couple of bots, you can simply copy and paste the script to use on other exchanges and digital assets. You can easily increase the size of your operation without investing in the infrastructure or having other overheads.
The Top Tools & Strategies for Successful Crypto Arbitrage Trading
When engaging in crypto exchange arbitrage strategies, you need to use various instruments to ensure that you do not miss out on many opportunities. We will talk about several important tools that you can use to make your coin arbitrage game a little bit fancier.
- Using automation. Manual vs. Automated Strategies is a battle of the digital age. There are proponents of strictly manual BTC arbitrage who believe that early success of companies like FTX and its founders is evidence that it works. However, the industry has changed a lot since then. Attempting to run a successful arbitrage cryptocurrency trading operation without employing bots is a futile endeavor.
- Pick the right platform. When it comes to cryptocurrency arbitrage software and platforms, choosing a company that offers a wide range of preset solutions and sufficient flexibility is quite important. For example, WunderTrading offers ready-to-go arbitrage setups, interesting premade products (DCA and GRID), and a rich catalog of other features.
- Use TradingView. While arbitrage may seem like a very simple system, you may want to expand on it and use forecasting tools to predict when good opportunities for cryptocurrency arbitrage trading will appear. It is possible to build analytical systems that can predict, broadly, the next period when there will be more opportunities for arbitrage.
Tips for Getting Started with Crypto Arbitrage Trading
Here are some things that you should do to build a good Bitcoin arbitrage trading system (or for any other cryptocurrency):
- Researching exchanges and markets to identify opportunities for profit. You should always look for centralized exchanges that will work well for arbitrage purposes. Sufficient liquidity, high trading volumes, and a large variety of traded assets are things to look for in an exchange.
- Setting up accounts on multiple platforms. For traditional cross-platform arbitrage you will need accounts on all exchanges you plan to use. Obviously, you will also need an account with an automation service and TradingView.
- Staying informed on market trends. Newsfeeds, notable influencers on social media, and financial experts can provide valuable insights and prepare you for the next period when arbitrage will be an excellent approach to trading. Consider setting up multiple alert systems on TradingView to be ahead of the market!
- Starting small and testing strategies before scaling up. Many novice retail traders make a grave mistake of investing a large sum of money and running hundreds of bots right from the beginning. Instead, focus on back-testing your strategies, learn more about arbitrage as you trade, and focus on preparing for upscaling in the nearest future!
- Research automation. The vast majority of contemporary arbitrage systems are operated by large-scale automated systems. Thanks to the advancements in this industry, you can build one without spending an absurd amount of money. Learn more about copying scripts and running multiple bots simultaneously.
While these tricks will help you get started, you must focus on spending. You can start slow by working with platforms like WunderTrading that allow all registered users to run up to five bots for free. It is an excellent opportunity to learn how to write scripts and launch bots before committing to paying for an upgraded subscription plan.
Using a sound financial management style is also quite important. Arbitrage is a very safe strategy, but it also does not produce outstanding results in the short term. Invest some money in risker endeavors to offset low returns from arbitrage. Use this system as a diversification tool that brings down the average risk level of your portfolio.
One last tip is to focus on sorting out details before scaling up. Make sure that your bots work as intended and produce desired outcomes. Test them vigorously for a sufficiently long period and start expanding only when you are confident in how your arbitrage bots perform!
The main takeaway
Many people believe that arbitrage can be used without a large capital and prior knowledge about the markets and the automation technology. It is not entirely true. Running a network of bots on multiple exchanges is a capital-intensive operation. You should also start from experimenting with automated trading systems and read as much as possible about arbitrage strategies.