Sometimes, the prices of cryptocurrencies may vary from one exchange to another. This scenario presents a good trading opportunity for arbitrage traders. In this article, we will focus on arbitrage trading. Keep reading to learn more about this type of trading.
Exploring Arbitrage Trading
Arbitrage trading involves exploiting price differences across various trading platforms. It is one of the positive outcomes of an inefficient, imperfect market model.
Arbitrage Crypto Trading
In crypto, arbitrage trading happens when you buy a digital currency at a lower price in one market and then sell it quickly in another market at a higher price. For instance, you may find Ethereum trading at $1,567 on Exchange X and $1,621 on Exchange Y. Therefore, you can buy it on Exchange X and sell it on Exchange Y, profiting about $44.
Price variances in crypto assets are largely driven by liquidity levels on various exchanges. Bigger exchanges tend to have high liquidity levels that can drive crypto prices. On the other hand, smaller crypto exchanges usually experience low liquidity levels, so they are unable to keep up with the prices on large exchanges.
Forms of Arbitrage Trading in Crypto
There are various forms of arbitrage trading in the cryptocurrency world. They include:
Simple Arbitrage
As the name suggests, Simple arbitrage is the easiest form of arbitrage trading. It involves a crypto user purchasing a digital asset from one exchange where it is priced low and selling it on another exchange where it has a higher value.
Convergence Arbitrage
In this form of arbitrage, a crypto user checks if there is a variance between the futures contract price and that of the underlying digital asset on the last day of delivery. Convergence arbitrage carries minimal risks compared to others.
Triangular Arbitrage
This form of arbitrage involves trading three pairs, usually on a single exchange. For example, a crypto user may discover that trading ETH for BNB could be profitable if they exchange BNB for Bitcoin and then trade BTC for ETH.
Advantages and Disadvantages of Arbitrage Trading in Crypto
Advantages
Quick Profits
Arbitrage opportunities don’t last for long. This means you can make considerable profits within a short time if you spot and execute them quickly.
Plenty of Opportunities
With hundreds of crypto exchanges available, there is a high likelihood that you will find an arbitrage opportunity. To identify such opportunities, use price aggregators like CoinMarketCap or CoinGecko.
Disadvantages
Huge Capital is Required
Unlike traditional crypto trading, which requires a small amount to get started, arbitrage trading demands huge investments to realize good profits. This creates a barrier for most retail investors who only have little capital.
Arbitrage Trading Risks
Execution Risk
As stated, arbitrage opportunities only last a few minutes. Therefore, failing to execute them early enough could put you into losses.
Counterparty Risk
This type of risk occurs when your order is not fulfilled in time by the other party involved in the trade.
Exchange Fees
Different exchanges impose varying trading, deposit, and withdrawal fees. So, it is important to be aware of these charges before executing an arbitrage trade. If they eat up all your profits, then the trade is not worth it.
Security
All crypto exchanges are vulnerable to cyberattacks. Therefore, it is important to understand that you could lose your money if you deposit it into a particular platform and it gets hacked.
Picking a Crypto Exchange for Arbitrage Trading
Total Fees
We have mentioned that the fees charged by various exchanges may affect your profits significantly. So, pick an exchange that imposes reasonable fees.
Trading Restrictions
In some cases, when an exchange realizes a huge difference between the crypto price shown on its platform and that on other exchanges, it may limit traders from doing certain activities like depositing or withdrawing the asset in question. So, always check if you have access to all features before executing an arbitrage trade.
Market Liquidity
Liquidity is key in crypto trading. Therefore, ensure an exchange has enough liquidity for fast trade execution so that you do not miss the arbitrage opportunity.
