How Does Arbitrage Trading in Crypto Work?

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When it comes to trading cryptocurrencies, knowing when to enter and exit the market is crucial. Timing is everything in trading. It determines how much profits you make or whether or not you’ll make profits. Trading cryptocurrencies could be confusing due to the price disparity. Prices often differ from one exchange to another due to the level of activity on the exchange. This is where arbitrage traders make their fortune.

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The Basics of Arbitrage Trading

Arbitrage trading benefits those who can take advantage of price differences on identical financial instruments on different platforms. Arbitrage trading is one of the most exciting outcomes of an imperfect, inefficient market model.

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Cryptocurrency Arbitrage

Cryptocurrency arbitrage occurs when you purchase a digital asset on one market so you can simultaneously sell at a higher price in another market. As an example, you could find Bitcoin trading at $7,500 on Exchange A and $7,550 on Exchange B. The difference might seem minuscule, but a trader with deep pockets that acts swiftly, can earn a tidy profit from a single transaction.

The cryptocurrency industry has a flurry of arbitrage opportunities. Larger exchanges have higher liquidity levels and can drive the prices of cryptocurrencies, but the smaller exchanges don’t always follow the prices set on their larger counterparts. In the time taken for these smaller exchanges to comply with market prices, arbitrage traders could seize the opportunity to make some money.

The Forms of Cryptocurrency Arbitrage Trading

Some of the most popular approaches you could take to cryptocurrency arbitrage trading include:

1. Simple Arbitrage

It’s the most common form of arbitrage available. To profit from this method, you only need to purchase a cryptocurrency on one exchange at a low price, then sell it at a higher price on another exchange.

2. Convergence Arbitrage

Under convergence, a trader buys a cryptocurrency on an exchange where it’s undervalued and then turn it on for a profit on another platform where it’s overvalued. This approach can be quite profitable if executed correctly.

3. Triangular Arbitrage

Triangular arbitrage is quite different from the simple form. Instead of merely buying one cryptocurrency on an exchange, you purchase three separate digital assets, with great care to watch for the imbalances on certain trading pairs. For instance, you could find that trading Bitcoin Cash for Ether will be profitable if you change Ether into Litecoin on one exchange, then change the Litecoin for Bitcoin Cash on a third exchange. Three exchanges, three digital assets. A perfect triangle.

Pros and Cons of Cryptocurrency Arbitrage Trading

Pros

A. Speedy Profits

The most significant benefit of arbitrage trading, of course, is the speed with which you could turn a profit. As opposed to conventional trading that could take time, arbitrage trading involves you waiting for the perfect opportunity and acting in an instant. Your earnings are instantaneous, as long as you’re able to find a market price discrepancy or an imbalance in prices across exchanges to take advantage of.

B. An Abundance of Opportunities

You also benefit from the fact that there are hundreds of cryptocurrency exchanges in the world today- with even more set to be launched over time. So, your opportunities are endless. Check on several popular (and even some unpopular) exchanges, and you should be able to find a discrepancy or two to take advantage of and make your money.

Cons

A. Massive Capital Requirements

Perhaps the first point to note here will be that only those who have the time, expertise, and funds to trade will be able to make the most. Conventional cryptocurrency trading can be carried out by just about everyone, no matter how much you have. However, if you want to go into cryptocurrency arbitrage trading and make significant profits, you will need to also back your purchases up by buying in bulk.

Risks Associated with Arbitrage Trading

1. Execution Risk

You can’t close more than one transaction at a time. So, a quick asset movement could occur in the time it takes you to get a deal completed, thus erasing your edge.

2. Counterparty Risk

This is the risk that occurs when the other party in the trade fails to fulfill its obligation. Keep in mind that you will need to make large trades to profit off an arbitrage transaction. When a counterparty suddenly fails to hold their end of the bargain, you stand to lose money as a result.

3. Exchange Fees

Cryptocurrency exchanges are centralized organizations that provide tools for trading cryptocurrencies for a fee. The fees are what makes them profitable.

The first exchange-related demerit here has to do with fees. All exchanges make money from trading fees, withdrawal fees, and deposit fees. So, besides looking for exchanges where you can sell high and make a profit, you also need to ensure that the exchange’s fees are low enough that they don’t eat much into the profits. When the fees surpass the revenues, the trade isn’t worth it.

4. Security

Like all centralized asset custodians, cryptocurrency exchanges pose the risk of being hacked, and since you will need to store your currency In the exchanges’ wallets, security threats could put your money at risk.

If you’re dealing in cross-border arbitrage trading (i.e., arbitrage trading on two exchanges that are based in different countries), you will also need to consider the Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations. Trading on some exchanges means that you’ll need to provide documents to verify your identity.

Selecting a Cryptocurrency Exchange for Arbitrage Trading

Here are the most critical factors to consider when choosing a cryptocurrency exchange to trade on:

Total Fees

Remember that various exchanges come with various fees for the main transactions- deposits, withdrawals, and trading. These fees would add up to your costs and, ultimately, decide the profitability of your arbitrage trades.

Locations and Restrictions

It’s also possible that some exchanges restrict several of their features based on the location of the traders. Before you make a trade or initiate a transaction, make sure that you have full access to the suite of services (or, at the very least, the services you need) on an exchange.

Reliability

The most crucial concern for traders is safeguarding their funds. Many arbitrage traders tend to wander off looking for prime opportunities and end up on unscrupulous exchanges, thus exposing themselves to risks. Every trader faces risks, but it’s always best you stick with exchanges that have a proven track record of reliability.

Account Verification Steps

These days, KYC measures are more vital than ever on cryptocurrency exchanges. Most of the regulated exchanges won’t allow you to trade a single asset unless you’re verified. This process alone could take days. As a rule of thumb, you should try getting all of these identify verification steps out of the way before you begin trading to ensure a seamless experience.

Market Liquidity

Another benefit of trading on large exchanges is for liquidity. For traders looking to purchase a very high amount of a cryptocurrency at a time, this is a crucial sticking point.

Now, that we’ve gone through some of the types of crypto arbitrage trading methods and the risks involved, it’s time to get started. Remember, the key principle with arbitrage is finding price discrepancies across exchange platforms. As long as you can find a reliable exchange, you’ll have no problem capitalizing on trading opportunities that would earn solid returns.

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Based in the United Kingdom, Jimmy is an economic researcher with outstanding hands-on and heads-on experience in Macroeconomic finance analysis, forecasting and planning. He has honed his skills, having worked cross-continental as a finance analyst, which gives him inter-cultural experience. He currently has a strong passion for blockchain regulation and macroeconomic trends as it allows him peek under the global bonnet to see how the world works.

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