TL;DR

Arbitrage is a relatively low-risk trading strategy that takes advantage of price differences between markets. Most of the time, it involves buying and selling the same asset (like Bitcoin) on different exchanges. Theoretically, the price of Bitcoin should be the same on Binance and other platforms. Any price difference between the two is a likely arbitrage opportunity.

This is a very common strategy in the financial investment sector, but it is a tool used mainly by large financial institutions. With the democratization of financial markets thanks to cryptocurrencies, there may be an opportunity for cryptocurrency investors to also make profits this way.

Introduction

What if you could guarantee that a trade will be profitable? How would it be? You would know before you even entered the trade that you would make a profit. Anyone with access to this kind of advantage would exploit it to the fullest.

Although there is no guaranteed profit strategy, arbitrage trading is the closest you will get to it. Investors compete fiercely for the opportunity to enter these types of trades. For this reason, arbitrage trades tend to generate very small profits and depend heavily on the speed and volume of each trade. This is why most arbitrage operations are done using algorithms developed by high-frequency trading (HFT) companies.

What is arbitrage trading?

Arbitrage is a trading strategy that aims to generate profit by buying an asset in one market and simultaneously selling it in another. This is typically done with identical assets traded on different exchanges. The price difference between these financial instruments should theoretically be zero, since they are literally trading the same asset.

The challenge for an arbitrage trader, or arbitrageur, is not only finding these price differences, but also being able to execute the trades quickly. Since other arbitrage traders will likely also see this difference in price (the spread), the profitability window will usually close very quickly.

Furthermore, because arbitrage trades carry little risk, returns are typically low. This means that arbitrage traders not only need to act quickly, but they also need a lot of capital to make the trade worthwhile.

You may be wondering what types of arbitrage trading are available to cryptocurrency investors. There are several types, so let's look at some of them.

Types of Arbitrage Trading

There are many types of arbitrage strategies that traders around the world use in many different markets. However, when it comes to cryptocurrency traders, there are a few distinct types that are most commonly used.

Currency arbitration

The most common type of arbitrage trading is exchange arbitrage, which occurs when a trader buys the same cryptocurrency on one exchange and sells it on another.

The price of cryptocurrencies can change quickly. If you look at the order books of the same asset on different exchanges, you will see that the prices are almost never exactly the same, at any given time. This is where arbitrage traders come in. They try to take advantage of these small differences to make a profit. This, in turn, makes the underlying market more efficient as the price remains in a relatively contained range across different trading platforms. In this sense, market inefficiencies mean opportunities.

But how does this work in practice? Let's say there is a difference in Bitcoin price between Binance and another platform. If an arbitrage trader sees this, he will want to buy Bitcoin on the platform with the lowest price and sell it on the platform with the highest price. Of course, timing and execution would be crucial. The Bitcoin market is relatively mature and exchange arbitrage opportunities tend to have a very small window of opportunity.

Futures Contract Arbitration

Another common type of arbitrage trading for cryptoderivatives investors is funding rate arbitrage. This occurs when a trader buys a cryptocurrency and hedges its price movement with a futures contract on the same cryptocurrency whose funding rate is lower than the cost of purchasing the cryptocurrency. Cost, in this case, means any fees that the operation may have.

Let’s say you have an amount of Ethereum. At the moment, you may be happy with this investment, but the price of Ethereum will fluctuate a lot. Therefore, you decide to hedge your price exposure by selling for a futures contract (shorting) of the same value as your initial Ethereum investment. Let's say the financing rate for this contract pays 2%. That is, you would receive 2% for owning Ethereum without any risk related to price variation, resulting in a profitable arbitrage opportunity.

Triangular arbitration

Another very common type of arbitrage trading in the cryptocurrency sector is triangular arbitrage. This type of arbitrage occurs when a trader notices a price discrepancy between three different cryptocurrencies and trades them for each other in a kind of loop.

The idea behind triangle arbitrage is to try to take advantage of the relative price difference between currencies (like BTC/ETH). For example, you could buy Bitcoin with BNB, then buy Ethereum with Bitcoin, and finally buy back BNB with Ethereum. If the relative value between Ethereum and Bitcoin does not match the value that each of these coins has in BNB, an arbitrage opportunity exists.

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Risks associated with arbitrage trading

Although arbitrage trading is considered relatively low risk, this does not mean it is zero. Without risk, there would be no reward and arbitrage trading is no exception.

The biggest risk associated with arbitrage trading is execution risk. This risk exists when the spread between prices closes before the trader is able to complete the operation, resulting in zero or negative returns. This could be due to slippage, slow execution, very high transaction costs, a sudden increase in volatility, etc.

Another major risk related to arbitrage trading is liquidity risk. This happens when there is not enough liquidity to carry out trades in the markets and complete the arbitration. If you are trading leveraged instruments, such as futures contracts, it is also possible that you will suffer a margin call if the market movement is contrary to your position. As always, it is essential to exercise adequate risk management.

Final considerations

Being able to take advantage of arbitrage trading is a huge opportunity for cryptocurrency traders. With the right dose of speed and capital for these types of strategies, you are able to execute profitable, low-risk trades in moments.

The risk associated with arbitrage trading should not be overlooked. Although arbitrage trading may denote something like “risk-free profit” or “guaranteed profit”, the reality is that there is enough risk involved to keep any trader on his toes.

Still have questions about arbitrage trading or statistical arbitrage? Check out our Q&A platform, Ask Academy, where the Binance community answers your questions.