This article will introduce you to arbitrage trading on the cryptocurrency market. Before we wade into this subject, it might be helpful to briefly explain what arbitrage trading is. An arbitrage trader attempts to take advantage of price differences on the same financial asset. Suppose a given financial asset is trading at a price of $5 on one exchange and $5.15 on another. This creates a possible arbitrage trading opportunity. An arbitrage trader might enter a buy order on the first exchange and a sell order on the second, buying the security at $5 and simultaneously selling it at $5.15, pocketing the $0.15 difference on each traded unit.
Typically, price differences arise as a result of various market inefficiencies. These become possible when multiple trading platforms or exchanges are involved.
With the advent of cryptocurrencies, arbitrage traders are no longer limited to trading traditional financial assets. Moreover, due to its decentralized nature and patchy regulation, the cryptocurrency market offers an ideal environment for arbitrage traders – it is more likely to have a large number of price differences from which you can profit.
There are two main types of cryptocurrency arbitrage trading.
The first type is the conventional one. It involves trading the same cryptocurrency on two different exchanges. For instance, the cryptocurrency Ethereum (ETH) is trading on the exchanges Binance and Kraken. Suppose you notice that ETH is trading at $178 on Binance and at $185 on Kraken. You would deposit funds on Binance, buy a certain number of ETC coins, transfer them to Kraken, and sell them there. The difference between the two (less the applicable commission fees – more on that later) is your profit.
The non-conventional type involves the use of multiple cryptocurrencies. With this type of arbitrage, the trader analyzes the market to find cryptocurrencies that enjoy some correlation with each other. Once a basket of such cryptocurrencies is created, the trader attempts to find a cryptocurrency that is undervalued and one that is overvalued. When a suitable pair is found, the trader enters a buy order for the undervalued cryptocurrency and a sell order for its overvalued counterpart. The trader then waits for the market to correct the prices – that is, for the overvalued cryptocurrency to head lower and the undervalued cryptocurrency to head higher. When the two converge, the arbitrage position is closed.
The non-conventional type of arbitrage trading requires a greater degree of sophistication, and arbitrage traders tend to stick to the conventional type. However, even conventional cryptocurrency arbitrage comes with a number of nuances and limitations that need to be considered before you decide to plunge into arbitrage trading.
Commission fees should always be taken into account. You can expect to pay a fee on your buy and sell orders. You might also have to pay a fee when transferring coins from one exchange to another, and perhaps even when you deposit or withdraw funds. This means that any profit that you expect to make from an arbitrage trade should be large enough to cover all the commission fees. If the spread between the prices is not sufficiently large, you will either break even or, worse still, lose money.
You also need to have the right tools to transfer coins between exchanges as quickly as possible. When it comes to arbitrage trading, time and speed are everything. The cryptocurrency market can be very volatile, and prices may change rapidly. If you don’t complete your arbitrage trade fast enough, you run the risk of an unfavourable price move that will work against you.
As price spreads on cryptocurrencies tend to be low, cryptocurrency arbitrage might be more suitable for traders with larger deposits. If you work with very modest amounts of money, you might struggle to turn a decent profit. At a minimum, you should have no less than $100 to make it worth your while. You should also brace yourself for increased competition as other arbitrage traders move in to take advantage of what is a growing and lucrative market. Finally, arbitrage trading involves a time commitment. You will need to constantly monitor prices to avoid missing out on arbitrage opportunities. If you’re not prepared to do that, it will be better to consider less time-consuming trading strategies. Keep in mind that it’s best to trade when the market is relatively calm to avoid being caught in a volatile market that turns against your position.
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That said, if you do the necessary research before getting involved with arbitrage, there is potential for success. Arbitrage trading can be profitable if you understand the risks and approach the market prepared. While cryptocurrencies continue to gain traction among investors, it remains a place where market inefficiencies exist and where the savvy arbitrage trader can do well.
BJF Trading Group Inc., Oakville, ON, Canada
Disclosure: This is a sponsored article