There are many ways to make money in the crypto space; Some are low-risk, while others are relatively high-risk. One of the low-risk ways is Arbitrage trading.
Some crypto traders only look for arbitrage trading opportunities across crypto exchanges and make good money from it. Everything that has a reward comes with its risks. In this article, I’ll be breaking down the meaning of arbitrage trading, the possible risks involved, and how arbitrageurs make money.
What is Arbitrage trading in crypto?
Arbitrage trading exists in all financial markets. It is the act of finding variations in the prices of assets across different exchanges and leveraging these differences to make profits.
For example, BTC is sold for $19,500 on Exchange X and $19,800 on Exchange Y, there’s a price gap which is an opportunity for an arbitrageur to make a profit by buying for a lesser price on Exchange X and selling higher on Exchange Y in a short timeframe or while the opportunity remains. The process can be repeated until the difference is cleared or the price balances out.
Why are there differences in asset prices?
The crypto market is extremely volatile and there are about 600 exchanges currently listed on CoinGecko, and over 500 on CoinMarketCap with varying popularity, trading volumes, and liquidity. This list only includes centralized exchanges. Trading on centralized (spot) exchanges works differently from decentralized exchanges.
Trading on Centralized exchanges (Cex(es))
Centralized exchanges are similar to banks; They require a user to create an account and complete KYC to get full access to the exchange’s features. In a centralized exchange, the user is not provided with a seed phrase (ownership of wallet), so their funds are stored and practically controlled by the exchange.
Trading works on a centralized exchange with the help of an order book and a machine that matches buyers’ and sellers’ orders on the order book. For example, if Bob places a buy order on BTC at $19,200 on Exchange X and Alice places a sell order on BTC at $19,200 on that same exchange, the matching system automatically matches their order and the order book is updated.
The order book changes every second as traders place buy and sell orders. The price of an asset on a centralized exchange is therefore determined by the most recent matched order of the asset on that exchange.
Trading on Decentralized exchanges (Dex(es))
Decentralized exchanges are more like the “free world” of crypto where every individual is responsible for storing their funds, executing trades, sending, and receiving tokens. Decentralized exchanges do not require registration before use nor does it require KYC; You simply connect your wallet and start trading.
However, trading works differently on decentralized exchanges where the order book is absent thereby eliminating the need for a matching system.
The order book of centralized exchanges is replaced with an Automated Market Marker (AMM). It is the AMM that determines the price of an asset on a Dex using some specified formula.
Trading is only possible on a Dex if there’s liquidity. Liquidity is provided by the users of a protocol who are incentivized to provide liquidity by depositing the required assets into a liquidity pool to enable seamless trading. As buying and selling occur on a particular trading pair, for example, BNB/BUSD; The liquidity pool balances out such that there’s always an equal amount of both assets in the pool.
Making huge buy or sell trades at once can cause a price gap between the asset price on that exchange and the market price (the average price of the asset across other dexes). This is where arbitrageurs come in. The price of assets across dexes is constantly put in sync with the help of arbitrageurs who keep buying and selling from one exchange to another and profiting in the process.
Types of Arbitrage trading strategies
Note that different people have different names for these strategies. However, the concept remains the same – to profit from differences in the price of an asset across exchanges or trading pairs.
Pure spot arbitrage
This involves spotting an asset with varying prices on different exchanges and proceeding to buy where the price is lower, sending it to the exchange where it is higher, and selling to profit from the difference.
This is also similar to the above terms of buying an asset for a price on an exchange and selling it for a higher price on another exchange. The difference here is the exchanges are in different regions. For a number of reasons, the price of an asset could differ on exchanges in different regions.
This involves spotting an arbitrage opportunity on two exchanges and opening opposite future trade positions on the exchanges depending on which is lower or higher than closing them when the prices finally balance.
For example, BTC is trading for $19,000 on Exchange X and $20,000 on Exchange Y; I can open a long position on Exchange X and go short on Exchange Y then close both positions when the prices are in sync.
This is when an arbitrageur trades the same asset on just one exchange but across different trading pairs just to end up with an increased quantity of his initial asset.
For example, you could trade between BTC/USDT, BTC/ETH, and BTC/USDC if you spot price differences in the pairs. The goal is to end up with more BTC than you started with.
Possible risks of arbitraging
The crypto market is extremely volatile and such volatility can cause you to encounter losses before completing the process of buying and selling during an arbitrage opportunity.
Arbitraging requires that the trader is fast enough to leverage the difference in the price of an asset across exchanges. During the process of deposit and withdrawal, a lot can happen to the state of the market.
Centralized exchanges restrictions
Remember I said centralized exchanges store your funds? Well, here’s why it can be a disadvantage. An arbitrageur could buy an asset and deposit it on an exchange and then find out that the withdrawal of that asset has been suspended or trading of the asset is paused. In such situations, the arbitrage opportunity is usually gone before the case is resolved. This can lead to unforeseen losses.
An arbitrageur can make mistakes in his calculations giving him the false impression of an arbitrage opportunity especially when trading the triangular strategy where he deals with quoting a particular asset in different currencies.
Low trading volume/liquidity
An important factor to consider before leveraging an arbitrage opportunity is the trading volumes of both exchanges or trading pairs. It is possible to buy an asset and not be able to sell it if there are no matching buy orders (on a cex) or if there’s no liquidity (on a dex).
To avoid buying an asset you can’t sell, ensure that there is sufficient liquidity and volume for the amount of the asset you intend to take the trades with.
Before trying any arbitrage strategy, ensure to do your due diligence and be sure you know what you’re doing.
The information in this article is for educational purposes only and not intended as financial advice, you’re 100% responsible for your financial decisions. Happy trading!