What is arbitrage?
In its simplest form, arbitrage is the process of buying stocks in one market and selling them in another to take advantage of pricing differences in different markets.
For example, a car manufacturer is priced at $45 on the NYSE, but trades at $45.30 on the SSE. The trader buys these shares on the NYSE and then sells them on the SSE, making a profit of 30 cents per share. This is a basic example of an arbitrage trade.
What is Crypto Arbitrage Trading?
Cryptocurrency arbitrage trading works similarly to traditional stock market arbitrage trading.
Just as arbitrage traders seek to generate returns by buying and selling across markets, cryptocurrency arbitrage traders seek to profit from different prices on different exchanges.
For example, an investor bought 100 Solana tokens at $14 each on the Coinbase cryptocurrency exchange and then sold them on the eToro exchange for $14.10 — meaning the investor made a profit of 10 cents per share by trading on the new platform.
Types of Cryptocurrency Arbitrage
The only significant difference between cryptocurrency arbitrage trading and stock market arbitration is that there is more than one way to do it.
Some common types of cryptocurrency arbitrage trades include:
Spatial arbitrage - Also known as geographic arbitrage, spatial arbitrage is when an investor simply buys a cryptocurrency on one exchange, sells it on another and pockets a profit. Investors can trade cryptocurrencies between centralized exchanges (CEX) or decentralized exchanges (DEX) and take advantage of technical inefficiencies (such as pricing delays) and listing differences on exchanges to profit.
Space arbitrage without transfers - the most common and simplest form of arbitrage trading. Investors hold a long position in a certain cryptocurrency on one exchange and a short position in the same cryptocurrency on another exchange. This means that investors can hedge against large losses and make small profits on price fluctuations on different exchanges.
Triangular Arbitrage – The triangular aspect refers to the three currencies involved in a triangular transaction – the two currencies and the fiat currency used. Triangular arbitrage works as follows:
Investors log into their cryptocurrency exchange or trading account and purchase one Bitcoin on their account using fiat currency, such as GBP or USD.
The investor transfers that Bitcoin to a different exchange or wallet and uses that Bitcoin to buy 10 Ethereum.
The investor then sells the currently held Ethereum at a price above the original Bitcoin cost and buys back the original Bitcoin at the starting price to complete the triangle.
While profitable if done correctly, these opportunities rarely occur and it is not a method that is often used by traders.
How to Find Crypto Arbitrage Opportunities
Knowing how to put an arbitrage trading plan into action is a good thing. However, the would-be arbitrageur must know how to spot these opportunities and act on them.
In order to discover lucrative cryptocurrency arbitrage opportunities, investors must:
Browse the markets to see price changes - Whether manually or using a tracking tool to do the heavy lifting, comparing cryptocurrency prices across a range of platforms is essential to knowing where to buy and sell. Specialist software can help investors scrape this data from across exchanges to highlight potential opportunities.
Use trading pairs - Exchanges help measure the comparative value between two cryptocurrencies or coins and fiat currencies. For example, an exchange may display on the interface that one Bitcoin token is worth X amount of Ethereum and vice versa. This value can be used to calculate the value of the token at the time of the transaction, making it easier to determine if the exchange rate is in your favor.
Keep up to date with currency exchange rates - Another important aspect of cryptocurrency arbitrage is tracking the exchange rates of fiat currencies. For investors who buy and sell cryptocurrencies on global CEXs and DEXs, knowing the movements of fiat currencies can affect the profits they make when they sell all their assets.
Advantages of Cryptocurrency Arbitrage
Although it is an uncommon strategy, cryptocurrency arbitrage has many potential advantages.
The main advantages of cryptocurrency arbitrage trading include:
Low Risk – Since cryptocurrency arbitrage trading usually involves buying and selling simultaneously or on different markets, traders hedge their losses by investing in the opposite direction, which means that trading risk is minimal.
Potential for fast returns - Carry trades have a fast turnaround - once investors spot an opportunity, they will take advantage of it. The fast nature of carry trades and currency conversions at the ideal rate means that profits can be realized in a matter of minutes.
Industry Volatility - Volatility is not usually associated with active financial investing, but it is an important component of arbitrage. Cryptocurrencies are inherently volatile. Since the supply and demand of tokens are largely based on speculation, the market is constantly changing - daily pricing errors and inefficiencies on many cryptocurrency exchanges are exposed every day. It is these inefficiencies that open the door for traders to profit.
Applicable to both bull and bear markets - Whether the market is rising or falling, the number of arbitrage opportunities remains the same. Although bull markets are more desirable, traders can hold both long and short positions and make money regardless of whether the market is bullish or bearish.
Disadvantages of Cryptocurrency Arbitrage
All investment strategies carry some degree of risk – and cryptocurrency arbitrage is no exception.
Some disadvantages of cryptocurrency arbitrage include:
Withdrawal Limits – Some cryptocurrencies limit the amount you can withdraw at any given time. Investors must be aware of these limits and choose exchanges that offer the cheapest withdrawal fees to maximize profits from short-term trading.
Trading Fees - All trading platforms and cryptocurrency exchanges will not let you buy, deposit or withdraw money or coins from your wallet without charging fees. Investors must consider these fees before engaging in arbitrage trading. The fees for buying, selling and withdrawing tokens or fiat currencies can exceed the profits earned from conducting a successful arbitrage trade, adding an extra layer of complexity for both new and experienced investors.
Slow transaction times – As competition for cryptocurrency market share intensifies, transaction times are increasing due to increased trading volumes. Since funds need to be quickly reallocated and withdrawn, slow wait times can result in investors making profits, missing out on opportunities, or losing money altogether.
Precise timing is required - All trading is relatively time sensitive, but none more so than arbitrage trading. When there is a mismatch in prices between exchanges and an opportunity presents itself, investors have minutes or even seconds to react and profit. Investors need to quickly mitigate the risk of the market moving against them, making it an approach best suited for experienced traders.
FAQ
Which coin is best for arbitrage?
Arbitrage can be performed using any cryptocurrency or token. However, currencies with high volatility are the most suitable as they offer more arbitration opportunities.
Cheaper tokens and memecoins like Dogecoin, Shiba Inu, and Cardano are more volatile and more accessible to investors with smaller portfolios.
Can I lose money doing cryptocurrency arbitrage?
As with any form of trading, if the market moves against you — or your inputs are incorrect — you can lose money with crypto arbitrage.
Unfortunately, trading has real-world consequences, so it is crucial to understand and practice on a paper account before committing personal capital.
For more information on how beginners can invest in cryptocurrency and the potential pros and cons of trading, check out our helpful guide!
Is Crypto Arbitrage Legal?
Cryptocurrency arbitrage trading is not only legal in most countries around the world, it is also encouraged.
It makes it easier for centralized and decentralized markets to have a stable supply of tokens to meet demand without affecting market prices, helping to eliminate market inefficiencies.
How to Learn Crypto Arbitrage?
When learning any form of trading, it is important to learn from the best and practice strategies in a safe environment.
Most exchanges offer investors the option of setting up a demo account. A paper account allows novice investors to set up and try out different investment strategies (including crypto arbitrage trading) without taking on the risks associated with committing money right away.