You can’t go anywhere in 2021 without hearing about cryptocurrency. It’s in the news and on the tip of seemingly everybody’s tongue. You probably have at least a passing knowledge of what Bitcoin is and how it works, but the world of cryptocurrency goes way beyond that.
Like any type of investing market, the world of cryptocurrency includes many types of assets, asset classes, and strategies. The more you know about all the relevant aspects of the market, the better poised you will be to make money.
To help you better understand one of the strategies used by crypto traders, we will take a look at one of them here: cryptocurrency arbitrage. We will explain what it is, the different types, how to use it to profit, and the risks associated with it. Please note, though, this is not investment advice nor do we offer investment advising here. We simply explain one strategy traders use. Here is a quick guide to cryptocurrency arbitrage.
In truly efficient markets, the price of an asset is the same across all markets and exchanges at all times. The price of precious metals such as silver and gold, for example, always reflects the true value of the asset and is uniform across exchanges. This makes these efficient markets.
In the world of cryptocurrency, there are many different exchanges and a high level of volatility, so information about a cryptocurrency can swing the price of an asset quickly. Because information travels at different speeds, some cryptocurrency exchanges might reflect this information sooner than others. This makes the market “inefficient.”
Cryptocurrency arbitrage is all about exploiting this market inefficiency for profit. Traders can buy crypto at a lower price on one exchange and sell it for a profit on another exchange where the price is higher. We will go into more detail on how it works below but if you really want to dive in deep, Cove Markets’ cryptocurrency arbitrage guide goes into even more depth on this topic.
In 2021, there are around 500 different cryptocurrency exchanges. There are big, well-known exchanges such as Coinbase, Kraken, BitMEX, Gemini, and Binance (just to name a few) as well as hundreds of smaller ones. These exchanges all have different levels of transparency, trade volume, and market makers. That means that the price of cryptocurrencies on one exchange may often lag behind on another exchange.
To provide a simple and easy-to-understand example, let’s say you are monitoring “Crypto X” on Coinbase. To do this, you can look at the order book which is often displayed as a candlestick chart. At any given time, you may see that the price of Crypto X is $100 on Coinbase but on Kraken, it is currently trading for $102. You then buy as much Crypto X on Coinbase as you can and sell it as quickly as you can on Kraken. That is cryptocurrency arbitrage in a nutshell.
All cryptocurrency arbitrage is not created the same though. There are two general types of arbitrage, simple and triangular. The simple version is the one explained above. An asset is priced slightly lower in one place than another and you buy it on exchange A and sell it on exchange B.
In simple arbitrage, the profit margins are generally quite small and in order to make a large profit, you need to purchase and sell at high volumes. In the example above, if you arbitrage 10 shares, you’ll only make $12. If you can do 100 or 1,000 shares though, now you’re making some real (and real fast) profit.
Triangular arbitrage is much more complicated and harder to find but also can allow you to gain large profits. It usually takes a specialized algorithm to find these opportunities. This type of arbitrage involves taking advantage of the difference in the conversion rate between assets on different exchanges.
Here’s an example of how triangular arbitrage: Using Crypto A, you purchase Crypto B on one exchange. Then, you buy Crypto C with Crypto B, usually on another exchange. Finally, you convert Crypto C back into Crypto A (either on the first exchange or a third exchange) and because of the difference in rates, you have your profits. This strategy is generally for the more experienced, tech-savvy trader.
The beauty of cryptocurrency arbitrage is that it is a time-tested strategy that has worked for a very long time across all types of inefficient markets. It is good for traders because it allows for quick profits. It’s good for the market as a whole because when traders exploit market inefficiencies, prices are brought closer together and the market comes closer to true efficiency.
Yet, arbitrage is not a fool-proof strategy that will always net a profit. There are plenty of risks that accompany this strategy as well. The crypto market is incredibly volatile and the prices move at an extreme pace. If you don’t time the trades perfectly, you could lose out. If the price jumps on the buying end or the price slips on the selling end, you can find yourself out of luck.
Another risk with cryptocurrency arbitrage is that trading volume differs on different exchanges. You can see your arbitrage opportunity and buy on one exchange but, when you try to sell it on the other exchange, you may find that the trading volume isn’t high enough and even though you have crypto to sell, there aren’t enough buyers. This can make you miss your arbitrage window.
The last thing you need to take into consideration is the trading fees on each exchange. These fees can differ greatly and if you don’t take them into account during the overall arbitrage process, these fees can wipe out the profit margin you think you had.
This is a quick strategy guide to cryptocurrency arbitrage. It is a great trading strategy to turn quick profits in an inefficient, volatile market like the crypto market. But beware–it isn’t always a guaranteed win. If it sounds like something you’re interested in, though, you should definitely learn more.
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