If you have been trading crypto for a while, you will have noticed the price variations across exchanges. Even bitcoin (BTC), the largest and most liquid cryptocurrency, trades at different prices on separate markets, opening up the opportunity for savvy traders to engage in crypto arbitrage trading. Read on to learn what crypto arbitrage is, how it works, and whether you can still make money within today’s market.
What Is Crypto Arbitrage Trading?
Arbitrage is the simultaneous buying and selling of an asset to profit from the imbalance in its price. Arbitrage trading entails traders exploiting the price variability of financial instruments on different markets.
Crypto arbitrage trading is a trading strategy where a trader buys a crypto asset on an exchange and sells it to another exchange to profit from a price deviation between the two markets.
For instance, you can purchase bitcoin at $29,982 on Binance but it’s currently trading at a bid price of $30,129 on Kraken. The discrepancy in the crypto exchange prices offers a $147 opportunity for arbitrage.
Based on this scenario, arbitrage trading may look simple but that isn’t always the case. Several factors influence arbitrage trading such as market risk, hidden costs, barriers to entry, and more.
Arbitrage traders take advantage of the inefficiency of the crypto markets, which leads to price discrepancies across global exchanges, opening up opportunities for arbitrage.
Interestingly, crypto arbitrage trading doesn’t only occur cross-exchange but also within a single exchange and exchanges in different regions.
How Does Crypto Arbitrage Work?
To understand how crypto arbitrage works, first, you need to know how the pricing of crypto assets works on exchanges.
In a centralized exchange (CEX), pricing depends on the most recent price at which a digital asset is purchased or sold, which becomes the real-time price of that asset on the exchange.
For example, if a trader places an order to buy BTC for $30,000, and it is the most recently matched order on the exchange, the price will become bitcoin’s latest price on the exchange.
On the other hand, most modern decentralized crypto exchanges (DEXs) rely on a different method to price their assets, called an automated market maker (AMM) protocol, which leverages smart contracts to replace the order book.
Decentralized exchanges use liquidity pools to maintain the prices of crypto assets. Each liquidity pool represents a crypto pair. For example, an ETH/SUSHI liquidity pool on SushiSwap allows you to convert your ETH to SUSHI tokens and vice versa.
A liquidity pool contains funds provided by liquidity providers (LPs) who deposit crypto assets to earn their corresponding share of the pool’s trading fees. The ratio of assets in the pool is balanced by utilizing a smart contract deployed by the decentralized exchange.
Types of Crypto Arbitrage Trading Strategies
There are several ways crypto arbitrage traders can make money off-market inefficiencies. They include
|Types of arbitrage
|Cross-exchange arbitrage is where a trader tries to make a profit by buying a cryptocurrency on one exchange and selling it on a different one.
|Spatial arbitrage happens cross-exchange but with the exception that the exchanges are located in separate regions. For example, you could take advantage of the price disparity of BTC/USDT in the US and Asia.
|Triangular arbitrage involves spotting price discrepancies of digital assets on a single exchange and executing a trade for profit.
For example, you can purchase XLM using BTC, sell XLM to ETH, and finally exchange your ETH for BTC. Three different crypto assets changed hands, hence the term ‘triangular.’
|Decentralized arbitrage involves exploiting price differences on DEXs and centralized exchanges.
|Statistical arbitrage deploys algorithms and trading programs to execute high-frequency arbitrage trading on different exchanges.
Pros & Cons of Crypto Arbitrage
Unfortunately, crypto arbitrage is not a free lunch. So let’s look at the pros and cons.
The potential for profit in crypto arbitrage is fast as you buy assets in one exchange and sell them on another, all in a matter of minutes. This is quicker than the traditional buy, hold and sell your assets at a later date when the price is right. This can take weeks, months, or years.
Wide Range of Trading Opportunities
Crypto arbitrage offers you a wide range of profitable opportunities. You can take advantage of the hundreds of global exchanges, markets, and crypto assets out there.
Crypto Market Is Yet to Mature Fully
The crypto market is still growing and there are plenty of inefficiencies across trading platforms, creating opportunities for arbitrage traders.
Less Competitive Space
Compared to traditional crypto markets arbitrage traders focus on a unique area of crypto trading, making it less crowded than normal day trading at crypto exchanges or arbitrage in traditional financial markets.
Speed s Essential
To be a successful arbitrage trader, you need to execute your trades quickly to profit from price differences of an asset from exchange to exchange. The downside to these trades is your transactions can drive up the buying price and result in a decline in the sale price of an asset. If not timed correctly, you may make a loss on a subsequent transaction.
The lack of liquidity on some exchanges makes it hard for arbitrage traders to make a profit as the exchange may not have enough volume to execute a large transaction. This means a trader may have to wait for a while to get the right buyer and risk missing the arbitrage window or altogether forfeiting the trade.
Exchange transaction fees may add up and eat into a significant chunk of your arbitrage profits.
Slow Transaction Speeds
When crypto markets are on the move it is common to have slow transactions or downtime at crypto exchanges. Arbitrage traders stand to lose money in such situations. You can counter this by having a large position of working capital at a few exchanges.
Some exchanges have withdrawal limits, which makes it difficult for crypto arbitrage traders to access their profits immediately.
Does Crypto Arbitrage Still Work for At-Home Traders?
Crypto arbitrage trading can be a lucrative opportunity for anyone in the crypto space looking for alternative ways to profit. However, people need to understand it is not as simple as it sounds.
There are several things to consider when buying an asset on one exchange and offloading it on another for a profit. For one, you need substantial capital to book meaningful profits.
Moreover, you need technical knowledge of markets, trading tools, and how to use arbitrage automation programs to do it on any decent scale. If you are doing it manually, then will likely end up being uncompetitive.
In fact, this strategy is primarily executed by professional traders and hedge funds using highly sophisticated algorithmic trading programs that execute arbitrage trades automatically when opportunities occur. As a result, manual arbitrage trading becomes extremely difficult, making it very hard for at-home traders to make money with crypto arbitrage trading unless they are using algorithmic trading programs.
Is Arbitrage Legal in Crypto?
Yes. Crypto arbitrage is legal. Similar to how arbitrage is used in the global capital markets, crypto arbitrage is a legal method that allows traders to earn a potential profit when an asset is selling cheaper in one exchange and at a higher price on a different exchange.
Digital currencies trade on different multiple exchanges, and oftentimes the price of a token will differ from one exchange to another. In addition, crypto arbitrage helps to improve market efficiency.
Is Arbitrage Really Risk-Free?
No, crypto arbitrage is not entirely risk-free. For starters, you can incur losses if you don’t execute the trade quickly so as to exploit the crypto price differences from one exchange to another while they are still profitable.
Additionally, not all crypto exchanges have similar or equal trading volumes. This makes it hard for a crypto arbitrage trader to make any profit, given that the exchange may have low volumes that aren’t enough to carry out a large transaction. A trader will therefore be forced to wait to get the right buyer and end up missing the arbitrage window or abandoning the trade altogether.
Transaction fees also vary from one exchange to another. If the exchange you are using to sell has high transaction costs, your potential profit will automatically become less.
Where Can I Find Arbitrage Opportunities?
Crypto arbitrage opportunities can be found on most centralized and decentralized exchanges, as both exchanges have varying prices for the different digital assets traded.
For centralized exchanges, the pricing of assets is dependent on the latest bid-ask matched order on the particular exchange. Simply put, the last price that a trader buys or sells a crypto asset on a centralized exchange is regarded as the asset’s real-time price. On the other hand, decentralized crypto exchanges utilize a different pricing method for crypto assets called an automated market maker (AMM). AMMs depend on crypto arbitrage traders to ensure the prices remain in line with those on other exchanges.
Is Crypto Arbitrage Taxable?
Yes, crypto arbitrage is typically taxable. Profits made from crypto arbitrage are considered capital gains on an income and are, therefore, usually taxable at a marginal rate. However, crypto arbitrage taxation depends on your jurisdiction and its existing tax laws. since tax laws are there are no uniform crypto laws globally.