What is Arbitrage Trading?

The Beginner’s Guide

Arbitrage trading is a relatively low risk trading strategy that takes advantage of price differences in different markets. Often times, the same asset (eg Bitcoin) is traded on different exchanges. In theory, Bitcoin’s price should be the same on Binance and other exchanges. Such a difference creates a possible arbitrage opportunity.

This approach is a very common strategy in the trading world. However, it has been preferred by major financial institutions until today. With the democratization of financial markets thanks to crypto currencies, there may be an opportunity to benefit from this strategy for those who trade cryptocurrency.

While there is no guarantee of profits, arbitrage trading is the closest. Traders are in a fierce competition for an opportunity to enter into these types of trades. Therefore, the profit in arbitrage trading is usually very low. Also highly dependent on speed and volume per transaction. This is why the majority of arbitrage trading is done by algorithms developed by high speed trading (HFT) companies.

Arbitrage Trading

Arbitrage trading is a trading strategy that aims to make a profit by buying an asset simultaneously from one market and selling it in another. This is usually done between different exchanges where the same asset is traded. The price difference between these financial instruments should in theory be zero because the traded assets are exactly the same.

The challenge for arbitrage traders (arbitrators) is not just finding these price differences. It is also the ability to trade quickly over these differences. Since other people are likely to see this price difference as well, the time to make a profit is quite short.

In addition, returns are often low, as arbitrage trading is generally low risk. This means that arbitrage traders need to act quickly and have a large amount of capital to make a decent profit.

You may be wondering what types of arbitrage trading can cryptocurrency traders use. We will now talk about these different types.

Arbitrage Trading Types

There are many different types of arbitrage strategies that people in different parts of the world and using different markets benefit from. However, when it comes to trading cryptocurrencies, some types are more common.

1. Stock market arbitrage

The most common type of arbitrage trading is exchange arbitrage, where the user buys the same crypto asset from one exchange and sells it on another.

The price of cryptocurrencies changes rapidly. If you look at the order book of the same asset on different exchanges, you will hardly ever see that the prices are equal at the same time. At this point, arbitrage traders step in and try to make a profit by taking advantage of these small differences. Thus, the market becomes more efficient as the prices on different trading platforms will remain within a certain range. In this context, market inefficiencies can mean opportunities.

So how does it work in this app? Suppose there is a difference in Bitcoin price between Binance and another exchange. When an arbitrage trader sees this, he or she will want to buy Bitcoin at the lower price exchange and sell it on the higher priced exchange. Of course, timing and execution is very important. Bitcoin is a relatively mature market and stock market arbitrage opportunities tend to have very short spans of opportunity.

2. Funding rate arbitrage

Another type used by crypto derivative traders is funding rate arbitrage. Here, the user buys a cryptocurrency and is hedged against price movements with a futures contract with a funding rate lower than the purchase cost of the same crypto. In this case, the expense means any fee the position may generate.

Let’s say you have some Ethereum. You may be happy with your investment for now, but the Ethereum price will fluctuate a lot. So you decide to hedge the price risk by selling a futures contract (short selling) for the same value as your Ethereum investment. Suppose the contract’s funding rate pays you 2%. This means that owning Ethereum will give you 2% without any price risk and you will have a profitable arbitrage opportunity.

3. Triangular arbitrage

A very common type of arbitrage trading in the cryptocurrency world is triangular arbitrage. This type of arbitrage is when the user notices price differences between three different cryptocurrencies and buys and sells them in some kind of cycle.

The underlying idea of triangle arbitrage is based on taking advantage of cross currency price differences (such as BTC / ETH). For example, you can buy Bitcoin with your BNBs, then buy Ethereum with your Bitcoins, and finally buy BNB with Ethereum again. An arbitrage opportunity arises if the relative value between Ethereum and Bitcoin is not equivalent to the value of each of these currencies in BNB.

Risks of Arbitrage Trading

While arbitrage trading is considered relatively low risk, that doesn’t mean there is no risk at all. There is no reward without risk, and arbitrage trading is no exception.

The biggest risk in arbitrage trading is the execution risk. This happens if the price differences are closed and you get zero or negative returns before you end the transaction. The price shift can be caused by slow implementation, unusually high transaction fees, a sudden increase in volatility, and so on.

Another big risk in arbitrage trading is the liquidity risk. This happens when there is not enough liquidity in the markets that you need to enter and exit to complete your arbitrage. You can also receive a margin call if you’re trading using leveraged tools such as a futures contract and the trade moves in the opposite direction of your forecast. As always, proper risk management is essential.

Final Thoughts

Taking advantage of arbitrage trading is a great opportunity for cryptocurrency traders. If you have enough capital to use such strategies and are fast, you can perform low-risk and profitable transactions in a short time.

The risks brought about by arbitrage trading should not be overlooked. Even though arbitrage trading gives the impression of “risk-free profit” or “guaranteed profit”, in fact, there is enough risk to cause everyone who uses this strategy to wait on alert.

Stay tuned to SinceCoin to learn more about Bitcoin and cryptocurrencies.

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