What Is Arbitrage Trading?
The arbitrage trading strategy uses price differences across markets to capitalize on relatively low risk. These transactions involve the purchase and sale of a single asset (such as Bitcoin) on multiple exchanges. A difference in price between Different exchange could represent an arbitrage opportunity since Bitcoin prices there should be equal.
In the world of trading, this is a strategy that is quite common. However, most financial institutions use it as a tool to deal with large transactions. It may be possible for cryptocurrency traders to profit from the democratization of financial markets due to cryptos, too, since cryptocurrencies are democratizing the markets through the use of them.
Introduction
How would you feel if you had the assurance of a successful trade? Could you imagine it? Before you even enter into the trade, you would have to be sure that you were going to make a profit. It is safe to say that anyone who was able to have such an advantage would make the most of it until their advantage was gone.
The closest you will get to a guaranteed profit is through arbitrage trading, even if it isn't a 100% guarantee. These types of trades are highly competitive with traders ferociously competing to get access to them. Because of this very reason, profits in arbitrage trading are relatively small and are determined by many different factors, such as speed of the trades and the volume of each trade. This is why high-frequency trading (HFT) firms are heavily involved in arbitrage trading, since they tend to develop algorithms for that purpose.
What is arbitrage trading?
Arbitrage trading is a strategy which involves simultaneously buying and selling an asset in two different markets simultaneously in order to generate profits. Similar assets are usually bought and sold on different platforms. Because these financial instruments are the same assets, there should be no price difference between them.
Arbitrage traders are faced with the challenge of finding these significant pricing differences, as well as trading them rapidly. The larger opportunity window for profitability usually closes very rapidly, because other arbitrage traders will also probably see the difference in price (the spread) as well.
Furthermore, arbitrage trades from a financial standpoint are generally low-risk and therefore, their returns are also usually low. In other words, arbitrage traders don't just have to act quickly, but they also have to have a considerable amount of capital to be able to do so successfully.
What types of arbitrage trading crypto traders have at their disposal is perhaps one of the most frequently asked questions. Let's get right into it and take advantage of different kinds of expenditures, so let's go over them in more detail.
Types of arbitrage trading
Trades all over the world in a wide range of markets use many different types of arbitrage strategies. It is nevertheless important to note that there are several types of cryptocurrency traders that are quite common.
Exchange arbitrage
In exchange arbitrage, trader buys cryptoassets on one exchange and sells them on another, and that is the most common type of arbitrage trading.
Cryptocurrencies can fluctuate in price rapidly. You will find that prices are almost never the same at the same time for the same asset on different exchanges if you examine the order books. These are the situations in which arbitrageurs are of use. These small differences are exploited to generate profit. The result is a more efficient underlying market since the prices remain relatively within a range across various trading venues. Market inefficiencies may therefore represent opportunities for investors.
What are the practical applications of this concept? Suppose two different exchanges have different prices for Bitcoin. It is possible that an arbitrage trader would find such a situation and might prefer to buy Bitcoin at the cheaper price on one exchange and sell it at the higher price on another exchange. There is of course some nuances pertaining to timing and execution in this regard. In the Bitcoin market, opportunity for exchange arbitrage has a very narrow window of opportunity due to its maturity, and the market tends to have fewer opportunities over time.
Funding rate arbitrage
For traders of crypto derivatives, funding rate arbitrage is another common form of arbitrage trading. This strategy involves hedging the price movement of a crypto asset with a futures contract in the same asset that has a funding rate lower than the cost of purchasing the crypto. If any fees are involved, then that's the cost.
Suppose you own a certain amount of Ethereum. The price of Ethereum is going to fluctuate all of the time, and you might be happy with that investment now. In order to mitigate your price exposure, you decide to short Ethereum for the same value as the Ethereum investment you have made. For example, a funding rate of 2% is paid for the Ethereum investment. This means that you would get 2% just by owning Ethereum without any price risk. The arbitrage opportunity produced by owning Ethereum would be very profitable.
Triangular arbitrage
In the cryptocurrency market, triangular arbitrage is another very common form of arbitrage. The arbitrage method involves a trading partnership spotting a discrepancy in the price of three different cryptocurrencies and then exchanging them with one another in this kind of loop.
A triangular arbitrage occurs when one takes advantage of the difference in price between two currencies (like BTC and ETH) to take advantage of the arbitrage. If, for instance, you purchased Bitcoin with your BNB, then purchased Ethereum with your Bitcoin, and finally purchased Bitcoin back using Ethereum. It is possible that there is an arbitrage opportunity if the value of Ethereum and Bitcoin are not equal to the value of each currency with BNB.
Risks associated with arbitrage trading
However, arbitrage trading is not considered to be a zero-risk strategy, even though it is considered to be relatively low risk. Arbitrage trading is no exception to this general rule, since without risk there is no reward.
As a result of arbitrage trading, execution risk is the biggest risk involved. The result is a zero or negative return when the spread closes before you’re able to finalize the trade, which is when the spread closes before you can finalize it. A variety of factors could lead to this situation, such as slippage, slow execution, abnormally high transaction costs, sudden spikes in volatility, etc.
Arbitrage involves a number of risks, including the fact that there is a risk associated with liquidity. If there is not enough liquidity in the markets that you need to trade to complete your arbitrage, this will cause you to be unable to get in and out of them. It is also possible that you may receive a margin call if you utilize leveraged instruments, such as futures contracts. As always, it is imperative that you exercise good risk management.