Cryptocurrencies trade on hundreds of different exchanges, and often the price of a coin or token may differ on one exchange versus another. That is where the strategy of arbitrage comes in: Similar to using arbitrage in capital markets, crypto arbitrage is a legal way to earn a potential profit when an asset sells cheaper in one market and at a higher price in another.
Here is a closer look at how crypto arbitrage works and trading strategies that use the tactic.
What is Crypto Arbitrage?
Cryptocurrency arbitrage is a strategy in which investors buy a cryptocurrency on one exchange and then quickly sell it on another exchange for a higher price. The strategy mainly works due to the price differences of the same assets across different exchanges.
The price differences come due to market inefficiencies. Large exchanges with high liquidity will set the standard price for the token, while smaller exchanges' prices will follow but not immediately. This is where the arbitrage opportunity comes in.
Arbitrage presents an opportunity to capitalize on slight price differences and repeatedly make tons of money by buying and selling in two different places.
Different Types of Arbitrages
There are many different types of arbitrage strategies.
1. Simple Arbitrage
Buy a coin on one exchange and sell it on another.
It takes time to send crypto over from one exchange to another (price difference can change by the time the asset is received) - Type of fees: ERC20 Gas Fees, exchange fees, selling fees, and withdrawal fees.
2. Crypto Triangular Arbitrage
Involves taking advantage of mispricing between coin pairs. As such, when you have three assets (two asset pairs) with one SHARED asset shared between the pairs.
For instance; $BTC/$ETH & $BTC/$LTC. In this case, $BTC is the shared asset, but there are three total assets.
The risk of such arbitrage is that some pairs will have a much higher trading price than the active trading price.
3. Convergence Arbitrage
This mainly involves Purchasing an asset that is undervalued on an exchange with the assumption the price will converge to the active trading price. One disadvantage of this type of arbitrage is that the asset will depreciate while you wait for the trading price to "catch up." Additionally, it requires a ton of capital to trade with "safe" coins.
Risks While Using Arbitrage
Exchanges issues like withdrawal limits and KYC.
High slippage.
Low Liquidity in that it cannot execute a trade at the desired price.
Gas trading and selling fees.
Transfer risk like it takes too long to transfer crypto between exchanges.
Taxes per trade.
Final Thoughts
Arbitrage exists across the capital markets, in stocks, bonds, and commodities, wherever the same asset trades for different prices in different places. Since cryptocurrencies are digital and aren't based on an underlying asset, it is harder to place a value on these currencies. They do not have the same pricing conventions as equities and bonds, which are tied to a company's performance, municipality, or nation.
Cryptocurrency is complicated, and arbitrage strategies can be even more complex. But the practice is legal and has the potential to yield high rewards while also exposing an investor to high risk.
As with any investment strategy, investors need to research crypto arbitrage, including looking at different, lesser-known cryptocurrencies and available software to track cryptocurrency exchanges in real-time.
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