If you’ve entered the investment world, it’s probably no surprise to hear about crypto market volatility. If you’ve followed it, you’ve probably noticed or experienced it firsthand.
However, did you know that there are also trading methods considered low-risk (compared to some advanced ones at least, such as leverage trading) that you can take advantage of and for which crypto market volatility is not so harmful but usually good?
One such way is facilitated by crypto arbitrage trading, which we’ll discuss in detail in this article.
Table of contents
- What is Crypto Arbitrage Trading?
- A Practical Example of Crypto Arbitrage Trading
- Crypto Arbitrage Trading Strategies to Keep an Eye On
- The Risks of Crypto Arbitrage Trading
What is Crypto Arbitrage Trading?
Crypto arbitrage represents a trading strategy in which crypto traders take advantage of small price differences of cryptocurrencies or cryptocurrency trading pairs across different markets and exchanges to generate profits.
Basically, it’s a trading strategy of purchasing crypto from one exchange and simultaneously reselling it to another, but at a greater price to generate profits.
Originally used with traditional assets, this trading strategy is now widely used in the global crypto markets; this is possible because cryptocurrencies are traded on multiple exchanges worldwide and because it is a highly volatile market compared to other financial markets, making this approach quite common and generally more lucrative for traders.
Typically, crypto exchange rates vary due to differences in supply and demand. That’s why a trader can benefit from these price variations to achieve low-risk profits in the crypto market.
Unlike traditional trading, which may involve fundamental analysis, technical analysis, or sentiment analysis knowledge, crypto arbitrage trading is relatively more straightforward.
That’s because the key is to identify crypto arbitrage opportunities and act on them promptly. Since cryptocurrency rates fluctuate every second, being alert and quick is crucial for successful cryptocurrency arbitrage.
How Does Crypto Arbitrage Trading Work?
So, as we already mentioned, crypto arbitrage trading is about profiting from the price discrepancies of cryptocurrencies between different exchanges.
To do that, crypto arbitrage traders monitor crypto asset prices across various platforms and regions, looking for instances where the same cryptocurrency is priced differently on other exchanges.
When a price gap is identified, traders promptly purchase the cryptocurrency on the exchange where it’s available at a lower price. This rapid action is taken to capitalize on the price gap before it diminishes.
After acquiring the asset, traders transfer it to another exchange with higher prices. Subsequently, they sell it at a high rate, generating profits from the price differential.
Remember that in most cases, this process is successfully accomplished through algorithmic crypto trading bots, which can complete this process much faster than an ordinary trader.
Thus, the chance of success in having higher profits is higher for those who use crypto trading bots, as these bots can instantly capitalize on buying a cryptocurrency and selling it on another exchange simultaneously.
SIDENOTE. Later in this article, you will discover that some crypto arbitrage trading strategies involve taking advantage of price differences even on the same exchange. Although it is possible to take advantage of price differences even on the same exchange, these are more isolated situations, and crypto arbitrage trading, in the vast majority of cases, refers to differences between exchanges, depending on the specific strategy being employed.
A Practical Example of Crypto Arbitrage Trading
So, let’s say that we have compared the prices of multiple cryptocurrencies on different cryptocurrency exchanges and spotted a spread in the price of Solana on two exchanges.
- Binance lists SOL (Solana) at $100.
- Coinbase, on the other hand, offers SOL at $96.
When we saw that difference, we bought 1 SOL on Coinbase for $96, then transferred it to our Binance account and sold it for $100. Of course, we did this in a matter of seconds in order to fully benefit from this crypto arbitrage. So, based on that crypto arbitrage, we generated almost $4 in profit (because we also paid trading fees).
You may say that’s not a profit worth the effort of constantly checking the market, but consider that we only bought and sold 1 SOL at that price. Think if we bought 1000 and sold at that price. Do you know how much we would have generated in that case? Approximately $4000, minus trading fees.
Crypto Arbitrage Trading Strategies to Keep an Eye On
Crypto arbitrage strategies are closely related to the types of crypto arbitrage that currently exist. Specifically, the types of crypto arbitrage also indicate the strategies of crypto arbitrage trades that can be taken.
Thus, two major strategies are distinguished, which break down into several smaller strategies – cross-exchange arbitrage and intra-exchange arbitrage.
Before delving into crypto arbitrage strategies that arbitrage traders use, remember that they often keep funds on multiple exchanges and use automated trading software with their exchange account API keys to identify and capture such price differences swiftly.
Also, some experienced traders even employ crypto arbitrage bots to automate the process, maximizing their potential profits.
1. Cross-Exchange Arbitrage
Cross-exchange arbitrage in crypto involves profiting from price discrepancies of a SPECIFIC CRYPTO ASSET across VARIOUS CRYPTO EXCHANGES.
Basically, this method ignores arbitrage trade opportunities on the same exchange where a cryptocurrency gap has been identified and considers only other exchanges.
The practice of cross-exchange arbitrage can be categorized into 5 main types and also strategies:
Standard cross-exchange arbitrage trading (also known as simple arbitrage) involves buying and selling crypto on two different exchanges to exploit minute-to-minute price differences to capitalize on the inherent price fluctuations.
Here’s an example to illustrate how it works:
Let’s say a crypto arbitrage trader identifies a price gap for ETH between two exchanges, Coinbase and Binance:
- Coinbase: ETH price at $2,300.
- Binance: ETH price at $2,350.
In this scenario, the trader can execute a simple arbitrage trade by purchasing 1 ETH on Coinbase and simultaneously selling it on Binance. This action would result in a quick, risk-free profit of $50 (excluding trading fees).
Spatial cross-exchange arbitrage is a variation of standard arbitrage with a unique difference: the exchanges are situated in different regions.
This strategy involves capitalizing on differences in the demand and supply of a cryptocurrency, such as Ethereum, between specific regions. Here’s how spatial arbitrage works:
For instance, using spatial arbitrage, you could exploit the difference in Ethereum prices between exchanges in America and South Korea. While global exchanges typically exhibit similar prices, region-specific exchanges may trade at a premium or discount. This discrepancy in prices becomes an opportunity for profit.
However, it’s important to note that local exchanges often restrict user sign-ups due to their focus on serving a smaller regional market. This limitation can be a downside to implementing spatial arbitrage.
Temporal arbitrage in crypto trading involves capitalizing on price fluctuations within the same market over time. It’s akin to buying an asset during a temporary price dip and selling it later when the price rebounds, profiting from short-term market swings.
Imagine buying an umbrella on sale on a sunny day, anticipating rain. You get it at a discount, wait for the inevitable downpour, and then sell it at a higher price to those caught unprepared.
For example, a sudden negative headline might cause a temporary drop in a cryptocurrency’s price. If you believe the negative news is short-lived and the asset’s fundamentals remain strong, you could buy at the dip. As the market corrects and the price rebounds, you sell the asset for a profit.
However, timing is crucial in temporal arbitrage. If the price doesn’t recover as expected, you might hold a depreciating asset.
Additionally, rapid market movements can make executing trades challenging, leading to missed opportunities or losses.
Decentralized crypto arbitrage comes into play when the price of a particular cryptocurrency on a decentralized Automated Market Maker (AMM) market significantly differs from the spot market on traditional exchanges.
Decentralized exchanges operate with Automated Market Makers (AMMs), which replace traditional order books. The AMM in decentralized exchanges sets the asset price within each liquidity pool by evaluating its internal supply and how it balances with its trading pair. This dynamic pricing mechanism means that the price of an AMM changes automatically based on demand within its own closed ecosystem.
Given that the closed DeFi ecosystem and its conditions influence the price, an arbitrage trader can take the opportunity created by the price difference.
This is done by buying a cryptocurrency on a decentralized exchange (DEX) and selling it on a centralized exchange (CEX) or reciprocally.
Statistical arbitrage uses statistical analysis to identify opportunities within a single or multiple markets. It relies on mean reversion, where related securities tend to return to their average prices.
In crypto, statistical arbitrage takes advantage of the market’s high volatility and inefficiencies. It involves analyzing historical data, identifying correlated pairs, and using statistical models, often implemented with Python or other advanced technical tools (like trading bots).
2. Intra-Exchange Arbitrage
Intra-exchange arbitrage in crypto involves profiting from price discrepancies of a crypto asset on a SINGLE EXCHANGE and ITS VARIOUS PRODUCTS.
There are 3 primary types of intra-exchange arbitrage:
Triangle arbitrage is a strategy that takes advantage of price discrepancies among three distinct cryptocurrencies or trading pairs, usually on a single exchange.
When we mention “usually,” it’s because triangular arbitrage can be employed as both an intra-exchange and cross-exchange strategy. However, it’s more commonly utilized as an intra-exchange strategy.
Depending on these variations, arbitrage traders can employ different techniques to profit.
If you’re considering this type of trading, it’s essential to possess a thorough understanding of cryptocurrencies and an advanced knowledge of arbitrage.
For crypto arbitrage trades, the most common instances of triangle arbitrage include using a buy-buy-sell order or a buy-sell-sell order.
Method 1: BUY — BUY — SELL (SOL/USDC → BTC/SOL → BTC/USDC)
1. Buy Solana (SOL) with USD Coin (USDC)
2. Buy Bitcoin (BTC) with Solana (SOL)
3. Sell Bitcoin (BTC) for USD Coin (USDC)
Method 2: BUY — SELL — SELL (BTC/USDC → BTC/SOL → SOL/USDC)
1. Buy Bitcoin (BTC) with USD Coin (USDC)
2. Sell Bitcoin (BTC) for Solana (SOL)
3. Sell Solana (SOL) for USD Coin (USDC)
These transactions, like any arbitrage trading, need to be executed rapidly. Delays in trade execution can occur due to exchange inefficiencies, and market volatility may lead to price changes before a trade is completed.
If the triangular arbitrage strategy seems challenging (and honestly, it really is without a trading bot), you can leverage trading bots, such as an arbitrage bot, with some coding knowledge to automate the process.
Funding Fee Futures/Spot Arbitrage
Funding rate arbitrage allows traders to capitalize on the price differences between futures and spot markets.
Many centralized exchanges (CEXs) provide the option to execute futures trades, enabling users to leverage their positions and speculate on the future prices of cryptocurrencies. In futures trading, traders can go long (betting on a price increase) or short (betting on a price decrease) for a particular asset.
The funding rate, a crucial concept in futures trading, involves long traders paying a fee to short traders if more people are longing than shorting, and vice versa. This funding rate sets the stage for funding rate arbitrage, a strategy that involves hedging futures trades by simultaneously taking a position in the spot market.
Here’s how funding rate arbitrage works:
An arbitrage trader enters a futures position to receive the funding rate. After that, it hedges this position with an opposite spot trade in order to profit from the funding rate minus trading fees, resulting in a net gain.
P2P arbitrage in crypto involves directly exchanging cryptocurrencies on peer-to-peer platforms without intermediaries like centralized or decentralized exchanges. In this case, arbitrage traders take opportunities where the same asset is offered at different prices on various P2P platforms.
Here’s a simplified guide to engaging in P2P crypto arbitrage:
First, you must identify a cryptocurrency with a notable price difference. After that, become a merchant, posting both buy and sell ads for the chosen cryptocurrency. Now, you only have to wait for counterparties to approach, facilitating buying at a lower price and selling at a higher one effortlessly.
Even if P2P arbitrage looks like a child’s play, remember that P2P arbitrage poses challenges. It requires time to find sellers offering assets below market rates. Moreover, quick action is crucial, as hesitation may result in missed opportunities. Also, fraud risks exist in P2P deals, demanding extra caution. Additionally, P2P platforms often have lower trading volumes, limiting potential gains.
Also, remember that manual research of arbitrage opportunities is time-consuming. While human traders face challenges, automated systems outperform in locating, identifying, and executing deals, making them more efficient in the fast-paced crypto market.
The Risks of Crypto Arbitrage Trading
Price slippages are probably the biggest crypto arbitrage trading risks, especially in markets with rapid price changes. As we already mentioned, crypto arbitrage is so loved by traders because the crypto markets are notoriously volatile, with prices fluctuating rapidly.
However, this can be a double-edged sword. In such a volatile market, slippage is expected to appear, and it occurs when there are differences between the predicted price of a trade and the actual execution price. This happens because the market’s price can change quickly between when a trader identifies an arbitrage opportunity and when the trade is executed.
If there’s a significant price movement during this period, the anticipated profit may be reduced, or the trade could result in a loss.
Transaction Fees/Transaction Costs
Transaction fees or transaction costs, say it how you want, are an essential risk of crypto arbitrage trading that you must consider.
Every trade on an exchange comes with fees, and crypto exchanges often have higher ones than traditional markets. These fees, especially for smaller opportunities, can quickly devour your profits.
Remember, you’re buying on one exchange and selling on another, doubling the fee impact. Watch out for hidden charges like deposit, withdrawal, and inactivity fees, as they can further harm your potential gains.
Not all coins are created equal. While major cryptocurrencies have high liquidity, many smaller altcoins can be illiquid, meaning there might not be enough buyers or sellers to fulfill your orders quickly.
This can lead to delays, missed opportunities, and potential losses. In illiquid markets, the bid-ask spread (the difference between buying and selling price) can be wide, further reducing your potential profit margin.
Cryptocurrency exchanges (both centralized exchanges and decentralized exchanges) are prime targets for hackers due to the large sums of money involved.
If an exchange you’re using gets hacked, your funds could be stolen, resulting in a complete loss. While less common, some fraudulent exchanges might vanish with user funds in an “exit scam.”
Choose reputable and established exchanges with a strong security track record to minimize this risk.
To succeed in arbitrage trading, executing trades fast and efficiently is essential to take advantage of price differences.
Any delays in execution, whether caused by technical issues, slow internet connections, or problems with the exchange, can lead to missed opportunities or potential losses.
What are the Advantages of Crypto Arbitrage Trading?
Crypto arbitrage can be lucrative due to its potential for quick profits. You could see earnings in minutes by capitalizing on short price discrepancies between multiple exchanges.
The ever-expanding crypto market, with new coins and exchanges emerging regularly, offers a constant stream of potential opportunities.
Additionally, the young market means less competition, potentially giving you an edge.
Finally, the inherent volatility of crypto can create more gaps between exchange prices, further increasing your chances of profiting from the market’s fluctuations.
What are the Disadvantages of Crypto Arbitrage Trading?
Crypto arbitrage might sound easy, but there are some catches. This includes that you’ll likely need a crypto trading bot to keep up with the fast-moving prices, and fees from buying, selling, and moving your money can eat into your profits.
Plus, the profits are usually small, so you’ll need a good chunk of money. On top of that, multiple exchanges limit how much you can take out at once, slowing down your access to your earnings.
If these sound like headaches, other investment options might be a better fit for you.
Is Crypto Arbitrage Profitable?
Crypto arbitrage trading has profit potential, especially when executed by experienced individuals with a deep market understanding. However, it’s crucial to manage expectations and acknowledge that arbitrage carries risks like any trading strategy. While some consider it a low-risk approach, losses are possible. Therefore, it’s essential to invest only what you can afford to lose and approach crypto arbitrage with a well-informed perspective.
Is Crypto Arbitrage Legal?
Yes, crypto arbitrage is legal in most jurisdictions. However, it is important to check with local laws to ensure you are not violating regulations.
After thoroughly exploring cryptocurrency arbitrage trading in this article, it’s evident that this strategy presents a viable option for generating additional income. However, while it’s deemed a low-risk trading approach, it’s crucial to note that low-risk doesn’t equate to risk-free.
Despite being less risky than alternatives like leverage trading, crypto arbitrage trading carries inherent risks that demand awareness.
Moreover, engaging in arbitrage trading without leveraging a crypto trading bot is increasingly challenging. So, consider investing in a reliable bot to navigate this complex landscape efficiently.
Choosing a suitable bot is essential, and extensive research is necessary to avoid pitfalls. Exercise caution and tread carefully to harness the benefits of this low-risk strategy for financial gains.