The growth of the cryptocurrency market continues apace. The rising popularity of cryptocurrencies owes itself, among other factors, to the decentralized nature of this market, the large number of cryptocurrency exchanges, and limited regulation. This growth presents new opportunities to traders. Specifically, different types of trading that have been possible with traditional currencies can now also be used with cryptocurrencies. In this article, I’d like to briefly consider one such type of trading – arbitrage. Arbitrage trading strategies have served forex traders well. There’s no reason why they shouldn’t serve them just as well when trading cryptocurrencies.
A brief overview of arbitrage trading is in order. Broadly speaking, arbitrage trading involves exploiting price differences that tend to arise from market-related inefficiencies.
For example, the same instrument (e.g., Bitcoin) can be offered at different prices on two different exchanges.
Seeing this difference, an arbitrage trader could buy a certain number of Bitcoins on the exchange with the lower price and sell it on the exchange with the higher price. The difference will be the trader’s profit.
These differences tend to happen in a decentralized environment in which there is relatively poor feedback and communication between different exchanges. In that respect, the cryptocurrency market offers an ideal environment for arbitrage trading.
However, while this kind of trading looks good on paper, arbitrage traders face a number of issues that are particular to the cryptocurrency market. As these issues might threaten arbitrage profits, you will need to take them into account if you want to apply arbitrage trading strategies to cryptocurrencies.
1. Commission fees. There are all sorts of commission fees associated with trading cryptocurrencies: buying/selling fees, transfer fees, deposit fees, withdrawal fees, etc. You need to factor all the commission fees that you can be expected to pay into your calculations. Your targeted spread should be large enough to leave you with a profit once the commission fees have been deducted.
2. Lags arising from time-related differences. It takes time to transfer cryptocurrencies between exchanges. To take advantage of a price difference between two cryptocurrency exchanges, for example, you will need to buy the cryptocurrency on one exchange and then move it to the exchange with the higher price in order to sell it. This process takes time, and many things can happen during that period. The longer it takes you to transfer the asset, the more room there is for the market to turn against you. That is, by the time the asset is moved to the other exchange, the price difference might have been corrected. The arbitrage opportunity will have been lost in this case. Additionally, there might be certain unscheduled technical upgrades on one of the platforms, which will increase the transfer time.
One way to address time-related differences is by having funds on several exchanges at the same time. That way, you’ll never need to physically transfer cryptocurrencies from one exchange to another. While this is a workable approach, there are drawbacks. It is inefficient to keep the same assets on multiple exchanges, and the approach requires extensive financial resources – not every trader has those. Additionally, you’ll still need to pay commission fees. You will also have less room for maneuvering, since you are effectively confined to a limited number of exchanges.
3. Liquidity issues. If you want to engage in arbitrage trading, expect competition. As more arbitrage traders continue to move in, the number of price differences will decrease and arbitrage profits will shrink. While certain cryptocurrencies such as Altcoins may still offer attractive price differences that can be exploited, these assets are far less liquid. Illiquid securities are harder to trade, and any advantage that you might have in terms of price can be easily lost as a result of poor liquidity.
4. “Intra-exchange” delays. There is another tactic that can be used to address the problems mentioned above: you can aim to exploit price differences between cryptocurrencies on the same exchange. This typically involves the use of three or more assets (e.g., two cryptocurrencies along with, say, the US dollar). However, the higher number of assets associated with the use of this approach means there is a greater risk of adverse price changes/movements during the time that you need to do the arbitrage trade. Also, bear in mind that some cryptocurrency exchanges create delays that will hinder arbitrage trading.
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As you can see, there are all sorts of nuances that should not be overlooked. You shouldn’t let them stop you, though. The cryptocurrency market is still very much in its growing phase, and for the astute arbitrage trader the opportunities are there. A judicious application of your trading strategy – one in which you take into account the limitations and costs of arbitrage trading on the cryptocurrency market, as outlined briefly in this article – should help you stay ahead of other arbitrage traders and, hopefully, trade profitably.