Introducing Cryptocurrency Arbitrage

Arbitrage can be a very effective trading tool when working with the cryptocurrency market. As cryptocurrencies continue to gain traction and widespread acceptance, there are many opportunities to make money. At the same time, there’s also more risk; and traders who are interested in cryptocurrency arbitrage need to be aware of it. If you’re one of those traders, this article is for you.

Arbitrage trading: what is it?

First, let’s define arbitrage trading. This kind of trading involves taking advantage of price differences that often crop up on financial markets in order to exploit the differences and make a profit. For example, for a number of reasons, the same financial instrument might be offered at different prices on two exchanges. The trader would simultaneously enter a buy and a sell order, purchasing the instrument from the exchange that has the lower price and, at the same time, selling the instrument on the exchange that has the higher price, thereby making a profit.

While this is a tidy way to make money, it has become very difficult for non-institutional traders to engage in arbitrage trading successfully with traditional markets. This is due to the fact that institutional market participants have been using increasingly sophisticated technology, eliminating the number of market inefficiencies and, consequently, the number of arbitrage situations present.

However, arbitrage trading can still be used profitably with cryptocurrencies. As the cryptocurrency market is a nascent market, it is vulnerable to inefficiencies that are far less common with a mature market; coupled with high volatility and volumes, this creates an environment that is conducive to arbitrage trading. Typically, such market inefficiencies as can be found come about as a result of the number of cryptocurrency exchanges in existence and the lack of industry consolidation: as large exchanges compete for business with small exchanges, demand and supply for the same coin can vary from one exchange to another. This is where arbitrage trading comes in.

Arbitrage trading and the cryptocurrency market

When engaging in arbitrage trading on the cryptocurrency market, there are a number of different strategies that a trader can utilize. The simplest one is called, appropriately one, simple arbitrage; it is centered on the simultaneous buying and selling of the same cryptocurrency on different exchanges. Another is called convergence arbitrage, which entails the purchase of a cryptocurrency on one exchange and the short sale of the same cryptocurrency on another; the trader then waits for the prices to be corrected by market forces. With triangular arbitrage, the trader exploits price differences between traditional currencies, buying and selling a cryptocurrency in these currencies to make a profit.

As an arbitrage trader, you also need to determine how you will scour the market for arbitrage situations. You can elect to do it the “old-fashioned” way, monitoring the market manually in order to identify an arbitrage situation. As this is a labor-intensive approach, though, there is an array of tools to help you, including arbitrage bots and trading applications.

Whichever strategy and trading approach are used, the objective is the same: to take advantage of an identified market inefficiency and make a profit.

An example

We’ll use a very simple example to illustrate how arbitrage trading works in real life. Let’s assume that you’re trading bitcoins (BTC). You’ve been monitoring the bitcoin price on two exchanges, ABC and XYZ, when you suddenly notice that the BTC price on ABC is $9,900 and the BTC price on XYZ is $10,000. Using simple arbitrage, you buy BTC on ABC for $9,900 and sell it on XYZ for $10,000, making a profit of $100 in the process. Naturally, this example, simple as it is, does not take into account any applicable transaction fees; but for illustrative purposes this will do.

Arbitrage trading: pros and cons

We’ve already mentioned several advantages of using arbitrage when trading cryptocurrencies. The cryptocurrency market is not a mature market, which provides fertile ground for all sorts of inefficiencies. It also offers a lot of volatility, which is important for arbitrage. Furthermore, there’s a plethora of cryptocurrency exchanges - the more exchanges there are, the greater the possibility of price differences and, therefore, profitable arbitrage situations.

However, with opportunities come risks. The cryptocurrency market has a number of drawbacks, pitfalls, and dangers that can hamper your ability to use arbitrage trading successfully and lead to losses. There might be all sorts of transaction fees that you’ll need to be aware of (cryptocurrency exchanges normally charge a transaction fee for trades), and there may be additional restrictions as well (e.g., daily limits on withdrawals placed on your wallet).

Due to the nature of arbitrage trading, you might have to constantly place large orders in order to make your arbitrage activity worthwhile. Also, the same volatility that is your friend when you’re involved in arbitrage trading can also be your enemy: high volatility can lead to price changes that will make it difficult for you to make a profit, since prices can change faster than you can transfer coins between exchanges. This is all the more so, given that slowness has been a problem with some cryptocurrencies and exchanges.

There are also safety concerns associated with storing coins on cryptocurrency exchanges. Crypto exchanges have experienced security breaches with their systems where traders’ coins are stored; coins can be stolen. Additionally, while the cryptocurrency market remains fairly unregulated, various regulatory requirements might prevent you from using certain exchanges, undermining your trading strategy.

Lastly, as cryptocurrencies become more popular, there’s a risk that arbitrage trading will become less effective as a growing number of sophisticated traders entering the market, combined with gains in technology, reduces market inefficiencies and the number of arbitrage situations.

Be aware and do your homework

Taking these risks into account will go a long way towards protecting your capital when using arbitrage trading on the cryptocurrency market. There are a number of things you can do to ensure that you mitigate the risk inherent in arbitrage trading when trading cryptocurrencies.

Stick to crypto exchanges that enjoy a sound reputation. Diversify - do not put too many eggs in one basket. Consider using hedging strategies. Be mindful of speed-related issues: transfer times with bitcoins, for example, are slow, so you might want to avoid using bitcoins when using arbitrage trading and consider other, more “speed-friendly” cryptocurrencies instead.

It is also a good idea to keep an eye on market developments, with two objectives in mind. One objective is to keep track of new coins that might be added to cryptocurrency exchanges: as newly added coins might not enjoy much demand initially on the exchanges on which they’ve just been listed, there might be price differences for you to exploit. The other objective is to be ready to trade when the market gets volatile (for example, when there is material news, etc.).

Finally, as with trading in general, make sure you have a solid action plan. You need to determine the amount of money you’re willing to trade and are able to lose, how you’ll transfer/store your funds, etc. Be sure to stick to your plan. Unless circumstances change to a point where the original plan is no longer workable, a good action plan will help you be more disciplined - always an important factor in trading success.

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Above all, make sure you understand the risks and do your homework. This will help you avoid mistakes and increase your chances of making money when engaging in arbitrage trading on the cryptocurrency market.