TL;DR
Arbitrage trading is a low-risk trading strategy that takes advantage of price differences across markets. Often, this involves buying and selling the same asset (such as Bitcoin) on different exchanges. Since Bitcoin prices, in theory, should be the same on Binance and on other exchanges, the difference between two exchanges is likely an arbitrage opportunity.
This is a very common strategy in the trading world, but is mostly practiced by large-scale institutions. With the democratization in today's financial markets thanks to cryptocurrencies, there may now be an opportunity for crypto traders to take advantage of it as well.
Introduction
What if you could guarantee that the trades you make always generate profits? What will it feel like? You know before even entering a trade that you will make a profit. Anyone who could have this kind of advantage would definitely exploit it until it was no longer possible.
While there is no such thing as a guaranteed profit, arbitrage trading is the closest thing. Traders compete fiercely for the opportunity to enter this type of trading. For this reason, profits are generally very slim, and depend heavily on speed and volume per trade. That's why most arbitrage trading is done with algorithms developed by high-frequency trading (HFT) companies.
What is arbitrage trading?
Arbitrage is a trading strategy that aims to generate profits by buying assets in one market and selling them in another market at the same time. This is most often done with the same asset traded on different exchanges. The price difference between these financial instruments, in theory, should be zero, because they are literally the same asset.
The challenge facing arbitrage traders, also known as arbitrageurs, is not only finding these price differences, but also being able to trade them quickly. Because other arbitrage traders tend to see these price differences (spreads) as well, the profitability window usually closes very quickly.
Additionally, because arbitrage trading is generally low risk, the returns are also quite low. This means arbitrage traders not only need to act quickly, but they need a lot of capital so that this activity does not go to waste.
You may be wondering what types of arbitrage trading are available to crypto traders. There are certain types that can be utilized, so let's get started.
Types of arbitrage trading
There are many types of arbitrage strategies utilized by traders around the world in various markets. However, when it comes to crypto traders, there are some that are quite commonly used.
Exchange arbitrage
The most common type of arbitrage is exchange arbitrage, which is when a trader buys the same crypto asset on one exchange and sells it on another exchange.
Cryptocurrency prices can change quickly. If you look at the order books for the same asset on different exchanges, you will find that prices are almost never exactly the same at the same time. This is where arbitrage traders come in. They try to exploit this small difference to make a profit. This will actually make the market more efficient as prices remain within a relatively controlled range across exchanges. In simpler terms, market inefficiency can mean opportunity.
How does it work? Let's say there is a Bitcoin price gap between Binance and another exchange. If arbitrage traders see this, they will want to buy Bitcoin on exchanges that have lower prices and sell them on exchanges that have higher prices. Of course, timing and execution are critical. Bitcoin is a relatively mature market, so exchange arbitrage tends to have a very small window of opportunity.
Funding cost arbitrage
Another common type of arbitrage trading for crypto derivatives traders is funding cost arbitrage. This occurs when a trader buys a crypto and hedges its price movements with a futures contract in the same cryptocurrency, which has a lower funding rate than the cost of purchasing the crypto asset. Fees, in this case, means any costs that the position may incur.
Let's say you own some Ethereum. Now you may be happy with this investment, but the price of Ethereum will fluctuate greatly. So you decide to hedge the price by selling a futures contract (shorting) for the same value as your Ethereum investment. Let's say the funding rate for the contract pays you 2%. That means you will earn 2% for owning Ethereum with no price risk, resulting in profitable arbitrage opportunities.
Triangular arbitrage
Another type of arbitrage trading that is very common in the crypto world is triangular arbitrage. This type of arbitrage occurs when traders find price differences between three different cryptocurrencies and exchange them for each other in a circle.
The idea behind triangular arbitrage is to try to take advantage of price differences across currencies (such as BTC/ETH). For example, you buy Bitcoin with BNB, then buy Ethereum with Bitcoin, and finally buy back BNB with Ethereum. If the relative value between Ethereum and Bitcoin does not match the value that each of those currencies has with BNB, there is an arbitrage opportunity here.
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Risks associated with arbitrage trading
Even though arbitrage trading is considered relatively low risk, that doesn't mean the risk is zero. If there is no risk, there will be no reward, and arbitrage trading certainly adheres to this understanding as well.
The biggest risk associated with arbitrage trading is execution risk. Occurs when the price gap closes before you can complete the trade, resulting in zero or negative profits. This can be caused by slippage, slow execution, very high transaction costs, sudden spikes in volatility, etc.
Another major risk is liquidity risk. This happens if it turns out that there is not enough liquidity for you to enter and exit the market to complete the arbitrage. If you trade using leveraged instruments, such as futures contracts, you may also be subject to margin calls if the trade is not in your favor. As always, implementing proper risk management is critical.
Conclusion
Being able to utilize arbitrage trading is a huge opportunity for crypto traders. With the right speed and amount of capital to participate in this type of strategy, you can make low-risk, profitable trades in no time.
The risks associated with arbitrage trading should not be ignored. Although this type of trading may give the appearance of “risk-free profit” or “guaranteed profit”, in reality, there is quite a lot of risk involved, which makes every trader remain alert.
Do you still have questions about arbitrage trading and its statistics? Check out our question and answer platform, Ask Academy, where the community will answer your questions.
