Understanding Crypto Arbitrage: Strategies for Low Risk in Crypto Trading
On the financial markets, one of the most potentially profitable, low-risk opportunities for traders is a strategy called arbitrage. Crypto Arbitrage involves capitalizing on asset price discrepancies across different exchanges. Since these discrepancies occur in all financial markets, arbitrage is a well-known practice across all asset classes.
Crypto Arbitrage Explained – What Is Arbitrage Trading in Crypto?
The crypto market is generally considered volatile and risky, however, swift price fluctuations create wide price spreads leaving windows for arbitrage trading. This is a process where a trader buys a currency at a low price on one exchange and sells it immediately on another exchange for a higher price.
For example, a trader who buys Ethereum on Binance for $2,520 and sells it for $2,540 on Coinbase will make a profit of $20 in a trade. Exploiting this price discrepancy is the gist of arbitrage trading.
How Does Crypto Arbitrage Work?
Crypto arbitrage works on the underlying principle that digital assets can have varying prices on different exchanges. The cryptocurrency market has an overall market cap of around $1.68 trillion. This is significantly less than the market cap of Apple alone. This means that the crypto market is significantly smaller than the equities market and is much more volatile. This volatility creates numerous discrepancies which can be leveraged to make profits in crypto.
Since these price fluctuations are instantaneous, time is of the essence in arbitrage trading. A typical arbitrage trader follows the below steps.
- Opportunity hunting — Arbitrage traders use tools to monitor the prices of an asset on multiple exchanges at the same time. The higher the discrepancy, the bigger the opportunity for making a good profit.
- Buying low — When a price difference is found, the trader buys the asset from an exchange that sells it for a lower price.
- Selling instantaneously — The previously bought asset is then sold instantaneously for a profit on a second exchange that has a higher price to offer.
- Calculating profits — Once the trade is executed, profits are calculated by excluding any fees associated with the trade.
What Are the Main Types of Crypto Arbitrage Strategies?
There are different types of crypto arbitrage strategies traders can employ depending on their risk tolerance and skill level. Each of these strategies has its own set of challenges, and depending on your preference you may wish to begin with one of the following commonly used arbitrage types:
Spatial arbitrage is a type of cross-exchange arbitrage where traders find opportunities in different global regions. Due to the difference in demand in different parts of the globe, some exchanges have differing asset prices. For example, a trader can compare the prices of an asset like Bitcoin on exchanges in America and Asia to check for discrepancies.
Triangular arbitrage is the act of moving your funds across 3 or more assets to capitalize on the price differences between trading pairs. A trader, for example, sells USDT for ETH, sells this ETH for BTC, and finally sells this BTC for USDT, forming a triangle of sorts. If the trades are successful, the trader would have more USDTs than in his initial position.
P2P arbitrage is a strategy that entails buying an asset from a P2P exchange and selling it to a higher bidder. This strategy is particularly popular among traders who live in regions where crypto exchanges aren’t legalized. Although this strategy is simple, it is effective. Traders exercise triangular arbitrage with P2P to make the most out of their trades.
How Can You Get Started with Crypto Arbitrage?
Crypto arbitrage might sound intimidating but some tools and platforms make the process easy for beginners. However, as a complete beginner to the space, you might want to first get on board with cryptocurrencies. This can be done by following these simple steps:
- Make a crypto exchange account
- Fund your exchange wallet
- Purchase a stablecoin to get started
- Learn to transfer tokens from exchanges to wallets
While you can purchase BTC, ETH, or other cryptos, the best way to get started is to buy a stablecoin since their price doesn’t fluctuate and there are a lot of trading pairs associated with these coins.
Essential Tools and Platforms for Arbitrage Trading
Once you familiarize yourself with the crypto market, the next step is to begin looking for tools that can assist with your arbitrage trading strategy. The list below serves as a beginner’s arsenal for starting arbitrage:
- Decentralized exchanges — Decentralized exchanges or DEXs are a great tool for arbitrage traders. These exchanges don’t rely on order books and use an Automated Market Maker system to price the currencies. For every trading pair, a liquidity pool is created for both currencies where traders voluntarily submit their funds to provide liquidity in exchange for rewards. The math-based pricing system often creates price disparities between centralized exchanges and decentralized exchanges. Since these exchanges are decentralized, the trades are executed instantaneously, also helping the traders with their arbitrage strategy.
- Arbitrage scanners — Arbitrage scanners are platforms that help users identify opportunities in the market. An arbitrage scanner tells you what platform is best to buy a particular asset and where to sell it for maximum profits.
- Trading bots — Some arbitrage opportunities are very short-lived To make the most out of such opportunities, arbitrage bots are used. Not only do these trading bots make swift trades, but they can also automate your arbitrage strategy to generate a consistent passive income.
Understanding Market Volatility and Price Discrepancies
Crypto is a relatively small financial market. Due to the smaller market cap of currencies, everyday trades affect the prices of assets a lot more as compared to forex and equities. Furthermore, the crypto space is decentralized and largely unregulated. Due to this, there is no standard price for these currencies and the value is driven by supply and demand. The volatility spreads coupled with varying trading volumes on crypto exchanges usually create discrepancies that are exploited by arbitrage traders.
Is Crypto Arbitrage Trading Risky?
Financial markets and investments all come with their advantages and disadvantages and no trading strategy is risk-free. Crypto arbitrage is no different.
Market Risk and Regulatory Concerns
The crypto market has a lot of regulatory gaps, which makes crypto arbitrage trading tricky in practice. Unregulated financial markets are susceptible to fraud and hacks. Since arbitrage traders have to keep their funds online (exchanges and hot wallets), there is a slim risk of losing your funds to hacks.
Other technical risks associated with arbitrage trading include:
- Exchange wallet control — Centralized exchanges store the funds of users in their wallets. The exchange going offline temporarily can be a huge setback for arbitrage traders.
- High trading fees — Withdrawal, deposit, trade fees, and credit card fees have to be considered and are often overlooked while calculating profits. High trading fees can chip away at trader profit margins.
- Low liquidity — For trades to execute perfectly, it is essential to check the liquidity on an exchange. Low liquidity can cause slippage, causinghe trade to be executed at a different price than the advertised rate.
- Timing — Arbitrage trading is all about timing. If anything goes wrong while executing the trade, the opportunity can be lost, resulting in a loss.
Arbitrage is a profitable strategy across financial markets. Since crypto is volatile and unregulated, the spreads are much wider which brings more risk and opportunity for arbitrage traders. To make the most out of such a trade, study the market closely, try to eliminate all the risks associated with the trade, and try to automate as much as you can to create a passive income stream.
- Is crypto arbitrage legal?Yes, crypto arbitrage is a legal practice. In fact, arbitrageurs promote market efficiency.
- Which crypto is best for arbitrage?Coins with high volatility are more suitable for arbitrage due to more inefficiencies and bigger spreads. However, they are also riskier.
- Is arbitrage profitable?Yes, crypto arbitrage has the potential to be profitable, though much depends on the tools skills and experince of the trader..
- Can you lose with arbitrage?Yes, there are several ways to end up in a loss with arbitrage. This includes hacks, exchange downtimes, slippage, and inefficiency of trade among other reasons.
- What is the minimum investment needed for crypto arbitrage?While there is no minimum price to start crypto arbitrage, it is generally a good practice to start with a medium to high capital since the profit margins are small.
- Can crypto arbitrage be automated?Yes, crypto arbitrage can be automated on arbitrage platforms and through trading bots.
- How does market volatility affect crypto arbitrage opportunities?Market volatility creates wide spreads. This creates inefficiencies across the market, bringing arbitrage opportunities for traders.