Carefully! Lots of text.
Arbitrage trading is a low-risk trading strategy that capitalizes on price differences in markets. It basically involves buying and selling a single asset (such as Bitcoin) on different exchanges. Since the price of Bitcoin on Binance and any other exchange should theoretically be the same, any difference between prices presents an opportunity for arbitrage.
This strategy, once common among large financial institutions, is now particularly popular in the trading world. By democratizing financial markets with the help of cryptocurrencies, traders also have a chance to take advantage of the benefits of the crypto industry.
Introduction
What if you could guarantee yourself a profitable trade? What would it look like? Before entering a trade, you must know that you will make a profit. Anyone who has this advantage will use it for as long as possible.
Although the concept of guaranteed profit does not exist, arbitrage trading is the closest option to it. Traders compete seriously for the opportunity to enter into these types of trades. It is for this reason that profits in arbitrage trading are usually small and largely depend on the speed and volume of each transaction. Thus, most arbitrage strategies are executed using algorithms that were developed by companies specializing in high-frequency trading (HFT).
What is arbitrage trading?
Arbitrage trading is a trading strategy whose goal is to make a profit by simultaneously buying an asset in one market and selling it in another. Most often, arbitrage is carried out on identical assets traded on different exchanges. Theoretically, the difference in price between these financial instruments should be zero, because they are the same asset.
The task of an arbitrage trader, or arbitrageur, is not only to find differences in prices, but also to quickly carry out transactions. Since other arbitrage traders can also see this difference in price (spread), the window of profitability usually closes very quickly.
Additionally, arbitrage trades are generally low-risk trades, which means mostly low returns. Thus, to make good profits, arbitrage traders not only need to make quick decisions, but also have a lot of capital.
If you are reading this article, then you are probably wondering what types of arbitrage trading are used among cryptocurrency traders. There are several types of use of arbitrage in cryptocurrency. Let's look at them.
Types of Arbitrage Trading
There are many types of arbitrage strategies used by traders around the world in a wide variety of markets. However, when it comes to cryptocurrency, there are several types that are most widely used.
Inter-exchange arbitration
The most common type of arbitrage trading is exchange arbitrage, where a trader buys a crypto asset on one exchange and sells it on another.
The price of cryptocurrency can change quickly. If you look at order books for the same asset on different exchanges, you will notice that prices at the same point in time are almost never the same. This is where arbitrage traders come into play. They try to exploit these small differences to make a profit. This, in turn, makes the underlying market more efficient as the price remains within a relatively limited range across different marketplaces. In this regard, market inefficiency may indicate opportunity.
How does this work in practice? Let's say there is a difference in the price of Bitcoin on Binance and on another exchange. An arbitrage trader wants to buy Bitcoin on an exchange with a lower price and sell it on an exchange with a higher price. Of course, timing and execution are critical. The Bitcoin market is relatively mature and exchange arbitrage is generally limited.
Funding rate arbitrage
Another common type of arbitrage trading among cryptocurrency derivatives traders is funding rate arbitrage. It means that a trader buys a cryptocurrency and hedges its price movement with a futures contract on the same cryptocurrency that has a funding rate lower than the cost of purchasing the cryptocurrency. The cost of the trade in this case means any commissions associated with the position.
Let's say you have some Ethereum. You may be happy with this investment, but the price of Ethereum will fluctuate wildly. You decide to hedge your existing funds by placing a futures contract to sell (short) the same amount as your Ethereum investment. Let's say the financing rate for this contract is 2%. This will mean that you will earn 2% for holding Ethereum without any price risk, resulting in a lucrative arbitrage opportunity.
Triangular Arbitration
Another very common type of arbitrage trading in the world of cryptocurrencies is triangular arbitrage. In this case, a trader notices a price discrepancy between three different cryptocurrencies and cycles between them.
The idea behind triangle arbitrage is to take advantage of price differences between currencies (such as BTC/ETH). For example, you can buy Bitcoin with BNB, then buy Ethereum with Bitcoin, and redeem BNB with Ethereum. If the relative value of Ethereum and Bitcoin does not match their value in BNB, an arbitrage opportunity arises.
➟ Thinking about where to start working with cryptocurrencies? Buy Bitcoin on Binance!
Risks in arbitrage trading
Even though the risk in arbitrage trading is considered quite low, this does not mean that it is zero. Without risk there is no reward, and arbitrage trading is no exception.
The biggest risk associated with arbitrage trading is execution risk. It occurs when the spread between prices closes before you complete the trade, resulting in zero or negative returns. This may be due to slippage, slow execution, abnormally high transaction costs, sudden increases in volatility, etc.
Another major risk when participating in arbitrage trading is liquidity risk. It occurs when you do not have enough liquidity to enter and exit the markets to complete the arbitrage. If you trade leveraged instruments (such as futures contracts), then if the market moves against you, you may receive a margin call. As always, risk management is key.
Summary
The ability to take advantage of arbitrage trading is an exciting opportunity for cryptocurrency traders. With enough speed and capital to engage in strategies like these, you can start making profitable, low-risk trades in no time.
The risk associated with arbitrage trading should not be overlooked. While arbitrage trading can theoretically produce “risk-free” or “guaranteed” profits, in reality there are enough risks to keep any trader on their toes.
