What Is Arbitrage Trading?
Arbitrage trading is a trading strategy that makes use of temporary price differences on various exchanges to earn a profit from buying and selling the same asset in different markets simultaneously. The existence of multiple crypto exchanges throughout the world, available around the clock, increases the likelihood of benefiting from such price discrepancies.
For example, once you spot a price difference in a crypto asset like Bitcoin on different crypto markets, you can purchase it at a lower price on one market and sell it at a higher price on another. This makes arbitrage trading a relatively low-risk way to earn a quick buck. That being said, arbitrage trading is highly dependent on inefficiencies between markets to create distinct price differences on the same asset. Hence, despite the continued volatility of cryptocurrencies, advances in blockchain technology may correct such price variances in the near future, making it harder to profit from arbitrage trading.
How Does Arbitrage Trading Work?
Crypto arbitrage trading essentially takes advantage of price discrepancies that occur across different crypto exchanges. Prices can vary among more than one asset, and even by quantity or geographical variances. Following are some examples of arbitrage trading.
Across Crypto Exchanges
The most basic crypto arbitrage takes place across different crypto exchanges which offer slight price disparities on the same asset. In order to profit, a crypto arbitrage trader needs to have an account on each exchange, with enough available funds. This allows the trader to buy and sell readily in order to capture temporary price differences, without being hindered by transaction lags that can take up to half an hour to process.
Across Geographical Borders
Price differences can also be found on crypto markets in different countries. For example, the price of Bitcoin may be different on a U.S.-based crypto exchange as compared to an Asian crypto platform. A trader will need to hold a cross-border account in order to buy and sell immediately through geographical arbitrage. This is especially true for the case of South Korean exchanges, which has led to the phenomenon dubbed as the Kimchi premium.
Although arbitrage trading most commonly uses the same asset, it’s also possible to perform a three-way trade across different assets to benefit from the price differences with each trade. For example, a trader may hold Bitcoin (BTC) and execute a buy-buy-sell order. An example would be buying a lower-priced Ethereum (ETH) with BTC and subsequently buying an even lower-priced Solana (SOL) with ETH, before selling SOL for more than the original BTC used to purchase ETH. This head-spinning technique is also known as triangular arbitrage.
Across Speed and Quantity
Crypto arbitrage trades can benefit institutional investors more than retail traders, due to the sheer quantity and speed. With assets in lower quantities, retail traders can only earn a marginal profit through passive observation of price differences in different markets. This results in higher latency, with larger time lapses before price differences can be spotted. Thus, institutional investors are in a better position to snap up better-priced assets, due to their high trading speeds with larger quantities.
Why Does Arbitrage Exist?
To reap the highest profit from crypto arbitrage, traders need to be persistent in monitoring different markets and quick to discover market inefficiencies that result in price disparities. While the profitability of crypto arbitrage can be rather small for individual retail investors, due to limited asset quantity, numerous arbitrage opportunities can occur throughout the week, helping traders earn a decent profit.
Ultimately, arbitrage exists due to inefficiencies across markets. Such inefficiencies can be especially pronounced in the crypto market, which is still growing and is generally volatile, leading to potential irregularities in pricing and information transmission.
However, with the rapid improvement in blockchain technologies, these inefficiencies may be quickly adjusted and corrected to match across markets. Therefore, a trader needs to act quickly in order to take advantage of the price differences to earn a profit through arbitrage. As a result, arbitrage trading allows you to earn a profit in a much shorter time than the traditional method of holding your crypto assets and selling them at a later date to earn a sizable profit.