Arbitrage is something offered by many platforms of automated trading and even by some exchanges. How does it work and why should you care about it? Arbitrage trading in crypto is not a novel idea but it became one of the mainstream trading techniques as many realized that there are dozens of exchanges and each may have a different price for a certain coin.
What is arbitrage trading?
The term was derived from the word “Arbitre” which means referee in French. In the 18th century, it was coined by a renowned French mathematician who was puzzled by how to choose the best place to settle any debt payments using the best exchange rate. During the following three hundred years, financiers expanded the term to cover any deals happening simultaneously on multiple trading platforms.
The easiest way to understand arbitrage is to imagine a dealer interested in making a profit on lobsters. They cost pennies close to the seaside but can be sold at a much higher price by residents of inland metropolitan areas. The plan is simple: purchase lobsters near the shore and sell them elsewhere. However, many caveats: transportation, storing, marketing, and selling all add up to a huge overhead cost.
If only there was a way to circumvent such issues and instantly buy and sell a commodity. We are still hundreds of years away from instantaneous teleportation, but the dream of simultaneous selling and buying is quite close to being a reality. Contemporary trading platforms allow such fantastical things to happen! Before we start talking about how to arbitrage crypto, let’s discuss arbitrage in traditional financial markets.
Ideas behind modern crypto arbitrage trading
Since the beginning of time, we had differences across various markets. Some territories valued specific resources more than others. Some resources were hard to procure and required more effort on the part of the person trying to get them. Minute discrepancies in many aspects determining the value of any given asset or commodity could shift local prices dramatically.
This pattern did not change with the arrival of financial markets where only commodities and stocks were traded. Even stocks have different prices across the globe. Despite the ever-increasing speed of exchange of information, many traders found ways to efficiently employ various arbitrage strategies to earn money.
Ho to do arbitrage? The answer is quite simple: you must purchase assets in one place while simultaneously selling them in another. If you purchase an asset for a lower price, you make a profit. The idea is so elegant and simple that one must be wondering how people across the globe did not catch up to this tactic. Well, they did.
What is price convergence?
The biggest issue that this particular strategy faces is price convergence. If enough traders engage in this activity for a long enough period, the market eventually catches up and prices equalize across different trading platforms. At some point, there will be no sense in trying to purchase something cheaper, as all prices will come to a single number regardless of where you look.
Price convergence is often the direct result of arbitrage or similar speculative activities. It happens across national borders and on a much smaller scale. Prices converge inevitably. However, all speculators have a certain period before it happens.
- The speed of convergence is determined by a variety of factors including:
- The number of traders participating in the market seeking the best arbitrage opportunities.
- The number of transactions that these individuals and enterprises conduct.
- The total volume of deals conducted within a certain period.
When a large group of people tries to sell a massive amount of assets or commodities on one exchange while simultaneously selling on another, the market will follow quickly and try to equalize the price to remove discrepancies. The speed with which it happens depends on the factors above. The same can be applied to crypto exchange arbitrage trading. However, it happens much quicker when trading crypto!
The lightning-fast internet and crypto arbitrage opportunities
It could be quite easy for crypto exchanges to block profits made by arbitrage by communicating tightly and controlling prices. However, it would never happen, since such activities would not only compromise the integrity of the market but could also reduce the potential earnings of some exchanges that would not be able to attract customers by better transaction and execution speed.
Some exchanges compete in the game of seconds not even minutes! Internet and high-capacity data transfers allowed for immense speeds of data transmission making it possible for a single trader to perform some macro-trades simultaneously. Add some scripting and automation to the mix and you have a way to completely negate any delays and achieve the ultimate dream of any arbitrage trader — instant order placement across different trading platforms.
You don’t even know what would a medieval trader give up to obtain such power. Modern people take this incredible thing for granted. Despite having this undeniable advantage, many traders fail to use it efficiently. Why is it so?
The weakness of a human’s body
Let’s take a short detour and talk about the limitations that our physical bodies have. While some humans are capable of unimaginable feats of endurance, the vast majority of people do not possess any special abilities to bypass the limits of physiology. Here are some factoids that could be interesting to us, traders:
- A human can survive approximately 270 hours without sleep. It is just over 11 days. The record was established once and was never beaten or even attempted to be beaten.
- Depending on physicality and previously accumulated energy, a normal person could live on nothing but water for up to 21 days.
- Hydration is also quite important. A body will die without water within 3 days, again, depending on the amount of liquid accumulated in tissues.
Other important factors that affect one’s general wellbeing, intellectual capacity, and decision-making are socialization, diet, and many other things. It is simply impossible for a regular person to maintain some level of performance without taking time off, eating, and sleeping. To keep a level-headed attitude, you also must talk to other people from time to time and make sure that you have a stable emotional balance.
Why does the condition of your body matter when it comes to bitcoin arbitrage trading? The answer is simple: you must be able to think properly and react quickly to the market situation at hand. One of the defining characteristics of modern online trading is speed. At the same time, most markets operate 24/7 making it impossible for many people to use various techniques of arbitrage cryptocurrency trading efficiently.
Modern automation and bitcoin arbitrage opportunities
It is not a secret that BTC is the most lucrative speculative asset out there. Some other coins are also quite interesting for any active investor looking to either expand their portfolio or seek quick gains. How to arbitrage bitcoin?
The general strategy looks as follows:
- Have accounts on at least two different exchanges with enough funds to place orders;
- Check BTC prices on both platforms simultaneously;
- When the price on one becomes higher, sell, while instantly buying on another;
- Pocket the difference in the corresponding pair (usually, USDT).
It is theoretically possible to use a bitcoin futures arbitrage strategy, but using leverage is just adding another layer of risks to a method that already has many risks associated with it. The process seems quite easy and requires little knowledge of technical analysis.
The problem here is that orders must be placed simultaneously to counteract any volatility affecting both exchanges. It is not only hard to achieve manually, you may simply be absent when a perfect opportunity presents itself. Since prices converge quickly when so many traders participate, you have tiny windows for good order placement when engaging with highly demanded assets.
On the other hand, you may increase your odds of finding a good moment for arbitrage when using obscure coins and tokens. However, you will be unlikely able to track the prices of multiple assets for long periods.
Bots are the best solution to this problem. They have several distinct advantages:
- Machines do not require any sleep, rest, or nourishment to operate normally;
- Their reaction time is absolute compared to what people are capable of;
- Robots do not have emotions and never make mistakes under pressure;
- Computers can process massive volumes of information effortlessly allowing them to track multiple assets simultaneously.
What is crypto arbitrage? It is an endless competition where the best and fastest traders usually take the crown. Bots make this competition much fiercer, but also allow more investors to enter the market. If you are interested in Bitcoin arbitrage trading, make sure to at least consider implementing specialized automation solutions in your strategy.
Can you earn crypto with arbitrage?
While most speculators prefer to keep their earnings in stable coins or fiat, it is possible to earn the difference in crypto. When it comes to pocketed Bitcoin profits, in analysis, one must use a variety of hypothetical assumptions such as:
- Will the value of Bitcoin maintain its upward course?
- Will the value of Bitcoin translate to fiat or stable coins that I can use?
It is crucial to remember that BTC’s price is volatile meaning that you must consider possible downtrends when calculating the actual profitability of trading activities where you use bitcoin as the main exchange medium.
Some people believe that the HODL strategy, which is the idea that you must keep your BTC for as long as possible to enjoy the immense value it will have in the future, is the most sensible thing to do. However, keeping all eggs in one basket is never a good long-term strategy.
The many risks of Bitcoin exchange arbitrage
There are several important risks to mention. While they have been theorized long before the modern era of instant data transferring, many are still relevant.
- Execution risk is the most common and apparent problem. Despite lightning-fast internet and massive data centers preventing any significant delays, it is impossible to place several orders exactly simultaneously. It means that a sudden price change can ruin your seemingly perfect timing.
- Liquidity risk is very common when engaging with obscure coins and tokens that may not have enough market interest to support active trading on multiple platforms. Some crypto assets are even available on some exchanges. When the demand is insufficient, you may find yourself in a situation when a short order that you place is simply not executed on time or at all!
- The mismatch is more common in crypto than it seems. The problem is that there are a lot of rug-pulls and other shady things happening in the market meaning that some obscure tokens maybe not be as expensive or not as cheap as they appear. It means that arbitrage targets an asset that cannot be evaluated properly.
- Technological risks are also significant to remember. While many traditional forms of this strategy do not involve active machine trading, crypto exchange arbitrage involves automation in most cases. Scripts may receive conflicting signals and operate at a delay due to bandwidth issues, and other problems that are related to the technology behind bots.
You should also keep in mind that most APIs are as fast or reliable as the exchange wants them to be. Some suspicions aside, it means that some APIs may not be good enough to react to instant order placements from third-party bots.
All these risks make arbitrage far less appealing than the ideal scenario suggests. Modern bots are capable of arbitrage and can do it quite well, but even they are subjected to various risks and issues. If you are looking for an ideal, foolproof, 100% reliable unicorn strategy, this is not it.
Where can you try your arbitrage ideas?
It must be noted that many exchanges offer good bitcoin arbitrage opportunities due to being often tied to national currencies and markets. It takes time to find a good company that operates within a certain territory and does not react as quickly to the US or European market. However, when you find a couple of exchanges that have API and often have prices of assets that deviate from bigger marketplaces, you can make a profit!
However, you should never forget that each exchange has its fees. These fees must be accounted for when thinking about arbitrage exchanges. Sometimes, these fees can be large enough to completely negate any profits that you make.
Below are some of the most widely known exchanges with API.
Binance does not require any introductions. It is the biggest crypto exchange in the world with over 17% global market share. With most of its clients coming from Europe and the CIS region, it is certainly a big player with more than enough liquidity. Many users from Asia and the Americas make this platform an international giant. Low fees and lots of assets to work with also increase its appeal to both individual investors and enterprises.
- Coinbase also has an excellent API allowing the use of many third-party tools including coin arbitrage bots and other automation instruments. Coinbase is one of the oldest platforms in the market and still holds a very impressive market share and has over $1.4 billion daily trading volume. Popular in many areas in the world, it is a good reference point for prices and market shifts.
- OKX is also a platform that you should never write off. Despite some controversies, it is still one of the biggest platforms in the SEA region, South Korea, and Japan. If you are interested in Bitcoin or Ethereum arbitrage, you must use this platform as the second exchange for shorting. Here, prices may be different from other international exchanges.
- Uniswap is a good choice for manual arbitrage. The platform is decentralized and does not have any direct connections to larger exchanges meaning that it may have prices that drastically differ from other places. The API is restrictive and does not allow for any use besides gathering information about certain pairs. It is not the best candidate for your automation needs, but it certainly can be part of your arbitrage strategy.
- Balancer is the biggest decentralized trading platform that has a large daily trading volume and offers a wide array of assets to work with. The platform is not integrated with many third-party providers meaning that it may not be available for automation purposes. However, prices here are nearly always slightly different from other services.
Is automation required?
The simplest answer is yes. You need automation to be efficient when trying any market arbitrage. Many issues described in this article indicate that a human will never outplay the system with many bots doing what you are trying to do. The only way to stay relevant is to employ better bots with smarter settings.
Your expertise and intuition are never fully removed from the equation. Despite automation, you need to tune the scripts and choose the right places to trade. Additionally, you are the one making the ultimate decision on whether to use bots in the first place. Again, you will most certainly require some forms of automation if you are not interested in long-term investments.
People who have conservative views on investing and consider HODLing for as long as possible are usually not interested in quick gains and won’t be the biggest fans of automation. However, speculators, risky investors, and professional traders never turn away from an opportunity to earn money easily. Arbitrage can be quite easy, but it demands preliminary research, good automation tools, and favourable market conditions.