Résumé

Arbitrage trading is a relatively low-risk trading strategy that takes advantage of price differences between markets. Most of the time, it involves buying and selling the same asset (like Bitcoin) on different exchanges. Since the price of Bitcoin should, in theory, be equal on Binance and other exchanges, any difference between the two is likely an arbitrage opportunity.

This is a very common strategy in the trading world, but it is primarily a tool used by large financial institutions. With the democratization of financial markets through cryptocurrencies, there could be an opportunity for cryptocurrency traders to benefit as well.


Introduction

What if you could guarantee yourself a profitable trade? What would that look like? You should know, even before entering the trade, that you are going to make a profit. Anyone who could have that kind of advantage would use it until it didn't work anymore.

Although there is no guaranteed profit, arbitrage is the closest thing to it. Traders compete fiercely for the opportunity to enter these types of trades. It is for this reason that profits are generally very slim in arbitrage trading and are highly dependent on speed and volume per trade. This is why most arbitrage trading is carried out by algorithms developed by high-frequency trading (HFT) companies.


What is arbitrage trading?

Arbitrage trading is a trading strategy aimed at generating gains by simultaneously buying an asset in one market and selling it in another. This is most often done between identical assets traded on different exchanges. The price difference between these financial instruments should, in theory, be zero because they are literally the same asset.

The challenge of an arbitrage trader is not only to find these price differences, but also to take advantage of them quickly. As other arbitrage traders are likely to see this price difference (the spread), the window for profitability usually closes very quickly.

Additionally, because arbitrage trading is generally low risk, returns are generally low. This means that arbitrage traders not only need to act quickly, but also have significant capital to make it worthwhile.

You may be wondering what types of arbitrage trading are available to cryptocurrency traders. There are several types of arbitrage trading that one can take advantage of.


Types of Arbitrage Trading

There are many types of arbitrage strategies that traders around the world use in many different markets. However, when it comes to cryptocurrency traders, some distinct types are quite commonly used.


Arbitrage inter-exchange

The most common type of arbitrage is exchange arbitrage, which is when a trader buys the same cryptoasset on one exchange and sells it on another.

The price of cryptocurrencies can change quickly. If you look at 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 attempt to exploit these small differences for profit. This makes the underlying market more efficient since prices remain within a relatively contained range across different trading sites. In this sense, market inefficiencies can be synonymous with opportunities.

How does this work in practice? Let's say there is a price difference for Bitcoin between Binance and another exchange. If an arbitrage trader sees this, he wants to buy bitcoin on the exchange with the lowest price and sell it on the exchange with the highest price. Of course, timing and execution would be crucial. Bitcoin is a relatively mature market, and exchange arbitrage opportunities tend to have a very small window of opportunity.


Arbitrage of financing rates

Another common type of arbitrage for cryptocurrency derivatives traders is funding rate arbitrage. This is a trader who buys a cryptocurrency and hedges its price movement with a futures contract in the same cryptocurrency, whose funding rate is lower than the cost of purchasing the cryptocurrency. The cost, in this case, is that of all the costs that the position may generate.

Let's say you own some Ethereum. You may be happy with this investment, but the price of Ethereum is going to fluctuate a lot. So you decide to hedge your price exposure by selling a futures contract (short sale) for the same value as your investment in Ethereum. Let's say the financing rate on this contract pays you 2%. This means you will get 2% for holding Ethereum without price risk, allowing you to get a profitable arbitrage opportunity.


Triangular arbitration

Another very common type of arbitrage in the world of cryptocurrencies is triangular arbitrage. This type of arbitrage consists of a trader observing a price difference between three different cryptocurrencies and exchanging them against each other in a sort of loop.

The idea of ​​triangular arbitrage comes from trying to take advantage of a price difference between two currencies (like BTC/ETH). For example, you can buy bitcoins with your BNB, then buy Ethereum with your bitcoins, and finally redeem BNB with Ethereum. If the relative value between Ethereum and Bitcoin does not match the value of each of these currencies with BNB, an arbitrage opportunity exists.


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Risks associated with arbitrage trading

Although arbitrage trading is considered relatively low-risk, this does not mean that the risk is non-existent. Without risk there is no reward, and arbitrage trading is certainly no exception.

The biggest risk associated with arbitrage trading is execution risk. This happens when the price gap closes before you can complete the trade, resulting in a zero or negative return. This could be due to slippage, slow execution, abnormally high transaction costs, sudden spike in volatility, etc.

Another major risk when arbitrage is liquidity risk. This happens when there is not enough liquidity to enter and exit the markets you need to trade in order to complete your arbitrage. If you trade leveraged instruments, such as futures, you may also be subject to a margin call if the trade goes against you. As always, it is crucial to exercise good risk management.


To conclude

Being able to take advantage of arbitrage trading is a great opportunity for cryptocurrency traders. With the speed and capital needed to participate in these types of strategies, you could find yourself executing profitable, low-risk trades in no time.

The risk associated with arbitrage trading should not be overlooked. Although arbitrage trading may involve a “risk-free profit” or a “guaranteed profit,” there is actually enough risk for traders to be cautious.