Arbitrage trading is a relatively low-risk trading strategy that takes advantage of price differences between markets. In most cases, this involves buying and selling the same asset (like Bitcoin) on different exchanges. Since the price of bitcoins should theoretically be the same on Binance and another exchange, any difference between the two is likely an arbitrage opportunity.
This is a very common strategy in the trading world, but it is mainly a tool of large financial institutions. With the democratization of financial markets thanks to cryptocurrency, traders can benefit as well.
What if you could guarantee yourself a profitable trade? What would it look like? You need to know before you start trading what you are going to make a profit. Anyone who could have such an advantage will use it until they can no longer.
While there is no guaranteed profit, arbitrage trading is the best you can get. Traders compete fiercely to enter these types of trades. It is for this reason that the profit in arbitrage trading is usually very small and highly dependent on the speed and volume of the transaction. This is why most arbitrage trades are executed using algorithms developed by high-frequency trading (HFT) companies.
What is arbitrage trading?
Arbitrage trading is a trading strategy aimed at making a profit by simultaneously buying an asset in one market and selling it in another. Most often this happens between identical assets traded on different exchanges. In theory, the difference in price between these financial instruments should be zero, because they are literally the same asset.
The job of the arbitrage trader, or arbitrageur, is not only to find these price differences but also to be able to trade them quickly. Since other arbitrage traders can also see this price difference (spread), the breakeven window usually closes very quickly.
In addition, since arbitrage transactions are generally low-risk, the returns are generally low. This means that not only do arbitrage traders need to move quickly, but they also need a lot of capital to make it worth it.
You may be wondering what types of arbitrage trading are available for cryptocurrency traders. There are several types that you can use, so let’s get down to business.
Types of arbitrage negotiations
There are many types of arbitrage strategies that traders around the world profit from in a wide variety of markets. However, when it comes to cryptocurrency traders, different types are used quite often.
Currency arbitrage
The most common type of arbitrage trading is exchange arbitrage, where a trader buys the same crypto assets on one exchange and sells them on another.
Cryptocurrency prices can change rapidly. If you examine the order books for the same item in different markets, you will find that prices are almost never the same at the same time. This is where arbitrage traders come in. They try to use these small differences to make a profit. This, in turn, makes the underlying market more efficient as the price remains in a relatively limited range across various trading platforms. In this sense, market inefficiency can be synonymous with opportunity.
How does it work in practice? Let’s say there is a difference in the bitcoin price between Binance and another exchange. If the arbitrage trader sees this, he will want to buy bitcoin on the exchange at a lower price and sell it on the exchange at a higher price. Of course, timing and execution will be critical. Bitcoin is a relatively mature market and exchange arbitrage opportunities tend to have a very small window of opportunity.
Funding Rate Arbitrage
Another common type of arbitrage trading for cryptocurrency derivatives traders is funding rate arbitrage. This is when a trader buys a cryptocurrency and hedges its price movement with a futures contract in the same cryptocurrency that has a lower funding rate than the purchase price of the cryptocurrency. Cost in this case means any costs that the position might incur.
Let’s say you have Ethereum. Now you may be happy with this investment, but the price of Ethereum will fluctuate a lot. Therefore, you decide to insure your price risk by selling a futures contract (short) for the same amount as your investment in Ethereum. Let’s say the funding rate for this contract brings you 2%. This would mean that you will receive 2% for owning Ethereum without any price risk, leading to a lucrative arbitrage opportunity.
Triangular arbitrage
Another very common type of arbitrage trading in the cryptocurrency world is triangular arbitrage. This type of arbitrage occurs when a trader notices the price difference between three different cryptocurrencies and exchanges them for each other in a cycle.
The idea behind triangular arbitrage comes from trying to exploit the price difference between currencies (like BTC / ETH). For example, you can buy Bitcoin with your BNB, then buy Ethereum with your Bitcoin, and finally buy back BNB with Ethereum. If the relative value of Ethereum and Bitcoin does not match the value of each of these currencies with BNB, there is the possibility of arbitrage.
Risks associated with arbitrage trading
While arbitrage trading is considered relatively low risk, that doesn’t mean it sucks. There would be no reward without risk, and arbitrage trading is certainly no exception.
The biggest risk associated with arbitrage trading is execution risk. This happens when the price spread closes before you can complete the trade, resulting in zero or negative returns. This could be due to slippage, slow execution, unusually high transaction costs, a sudden spike in volatility, etc.
Another major risk in arbitrage trading is liquidity risk. This happens when you lack the liquidity to enter and exit the markets that you must trade in order to complete your arbitrage. If you are trading leveraged instruments such as futures, it is also possible that you will face a margin requirement if the trade goes against you. As always, it is important to manage your risks well.
Final Thoughts
The opportunity to profit from arbitrage trading is a great opportunity for cryptocurrency traders. With the right amount of speed and capital to engage in these types of strategies, you can make profitable low-risk trades in no time.
The risk associated with arbitrage trading should not be overlooked. While arbitrage trading can include “risk-free profits” or “guaranteed profits,” the reality is that there is enough risk to keep any trader on their toes.
