Summary

Arbitrage trading is a relatively low-risk trading strategy that exploits price differences between different markets. Most often, this involves buying and selling the same asset (such as Bitcoin) on different exchanges. In theory, the price of Bitcoin on Binance and another exchange should be exactly the same, so any difference between the two could be an arbitrage opportunity.

This is a very common strategy in the trading world, but it is mostly used by large financial institutions. With the democratization of financial markets brought about by cryptocurrencies, there may also be an opportunity for cryptocurrency traders to take advantage of this strategy.

Introduction

What if you could guarantee a profitable trade? What will it look like? Before you enter a trade, you're already sure you're going to make a profit. Anyone who has this advantage will do everything possible to take advantage of it.

While there is no such thing as a guaranteed profit, arbitrage trading is the closest option. Traders compete fiercely for the opportunity to enter such trades. Because of this, profits from arbitrage trading are often very slim and depend heavily on the speed and volume of each trade. This is why most arbitrage trades are conducted through algorithms developed by high-frequency trading (HFT) companies.

What is arbitrage trading?

Arbitrage is a trading strategy designed to generate profits by buying an asset in one market and selling it in another, often by trading the same asset on different trading platforms. In theory, the price difference between these financial instruments should be zero because they are effectively the same asset.

Arbitrage Traders The challenge for arbitrageurs is not only to find these pricing differences, but also to be able to trade them quickly. Because other arbitrage traders may also spot this price difference (spread), the profit opportunity is usually fleeting.

On top of that, since carry trades are generally low risk, the rewards are usually low as well, which means that carry traders not only need to act quickly, but also need a lot of capital to make the opportunity worthwhile.

You may be wondering what types of arbitrage trades are available to cryptocurrency traders. Of course there are some types that you can use, so let’s get right to the point.

Types of arbitrage trades

Arbitrage strategies are diverse and can be exploited by traders in different markets around the world. However, there are some different types that are very commonly used by cryptocurrency traders.

Trading platform arbitrage

The most common type of arbitrage trade is exchange arbitrage, where a trader buys a crypto asset on one exchange and sells the same crypto asset on another exchange.

Cryptocurrency prices can change rapidly. If you look at the order books for the same asset on different trading platforms, you will see that the prices on the different platforms are almost never exactly the same at the exact same time. This is where arbitrage traders can come into play. They try to profit from these small differences. This in turn makes the underlying market more efficient, as prices are kept within a relatively limited range across different trading platforms. In this sense, market inefficiencies may represent opportunities.

What does it look like in practice? Suppose there is a difference in the price of Bitcoin on Binance and other exchanges. If arbitrage traders notice this, they will want to buy Bitcoin at a lower price on one exchange and sell it at a higher price on another exchange. Of course, timing and execution are crucial. Bitcoin is a relatively mature market, and opportunities for exchange arbitrage opportunities are often fleeting.

Funding rate arbitrage

Another common type of arbitrage trade among crypto derivatives traders is funding rate arbitrage. This is when a trader purchases a cryptocurrency and hedges its price movements with a futures contract on the same cryptocurrency, which has a funding rate lower than the cost of purchasing the cryptocurrency. In this case, the cost refers to any fees that may be incurred by the position.

Let's say you own some Ethereum. You may be happy with your investment now, but the price of Ethereum will fluctuate wildly. Therefore, you decide to hedge your price risk by selling futures contracts (going short) at the same value as your Ethereum investment. Assume the funding rate for this contract is 2%. This could mean you could earn 2% on the Ethereum you own without any price risk, opening up a lucrative arbitrage opportunity.

triangular arbitrage

Another very common arbitrage trade in the cryptocurrency world is triangular arbitrage, which is when a trader notices the price discrepancy between three different cryptocurrencies and then swaps them with each other in a circular fashion.

The idea behind triangular arbitrage comes from trying to exploit price differences across currencies (think Bitcoin/Ethereum). For example, you could use your Binance Coin to buy Bitcoin, then use the Bitcoin to buy Ethereum, and eventually use the Ethereum to buy back Binance Coin. If the relative value between Ethereum and Bitcoin does not match the value between these two currencies and BNB, an arbitrage opportunity exists.

➟ Want to start your digital currency journey? Welcome to buy Bitcoin on Binance!

Risks associated with arbitrage trading

Although carry trading is considered relatively low risk, this does not mean that it is risk-free. Without risk, there is no reward, and carry trading is certainly no exception.

The greatest risk associated with arbitrage trading is execution risk. When the price difference disappears before you complete the trade, it results in zero or negative returns. This could be due to sliding spreads, slow execution, unusually high transaction costs, sudden spikes in volatility, and more.

Another major risk when engaging in carry trades is liquidity risk. This risk arises when there is not enough liquidity to get you in and out of the market you need to trade in order to complete your arbitrage. If you are trading with leveraged instruments, such as futures contracts, you may also receive a margin call if a trade moves against you. As always, it is vital to exercise proper risk management.

Summarize

Being able to take advantage of arbitrage trading is a great opportunity for cryptocurrency traders. As long as you have the right speed and capital to engage in these types of trading strategies, you will find yourself executing low-risk profitable trades in a short period of time.

You also shouldn’t ignore the risks associated with carry trading. While carry trading may imply “risk-free profits” or “guaranteed profits,” the reality is that the risks involved are enough to keep any trader on their toes.