Ready to take your cryptocurrency investment to the next level and take advantage of the constant price movement? Crypto arbitrage will probably seem like an attractive prospect – who doesn’t like the idea of buying cryptocurrency in one place and selling it at a profit elsewhere?
When done successfully, crypto arbitrage can literally mean making money out of thin air. But if done wrong, it can mean a huge waste of money, so make sure you know what you are doing before you get down to business right away.
Keep in mind that arbitrage is different from researching and then investing in cryptocurrency in the long run, so if you are interested in learning more, we will explain what crypto arbitrage is, how to do it, and if you are willing to profit from it.
What is Crypto Arbitrage?
In simple terms, crypto arbitrage means buying a cryptocurrency on one exchange and selling it at a higher price on another exchange, which allows you to make a profit. This process is possible because there are different crypto exchanges and their prices are regulated differently depending on their liquidity and how quickly they move to general market prices.
For example, if you buy one bitcoin for $ 42,000 on Binance and then sell it for $ 42,500 on Huobi, you have successfully earned $ 500. In fact, such a high profit is unlikely given that most platforms are cutting it, but certainly something can be done if you’re smart – we’ll explain how soon.
Arbitrage is different from other trading strategies in that you are not taking advantage of price changes over time – you are taking advantage of price differences between exchanges.
By the way, this phenomenon is typical not only for cryptocurrencies. You can also arbitrate foreign exchange, stocks, precious metals and other assets. People have been arbitrating for centuries!
However, you may find it easier with cryptocurrencies than with more traditional assets as it is a newer and less efficient market. Several large exchanges significantly affect the prices of smaller exchanges (which adapt more slowly).
Types of arbitration
You should now understand the main point. But did you know that there are several different types of cryptocurrency arbitrage, each of which works slightly differently? Yes, that’s right – just as you thought you knew everything, we throw you a crooked head.
Make sure you know the difference between the following:
- Spatial arbitrage: This type of arbitrage involves buying a cryptocurrency on one exchange and immediately selling it on another for additional money.
- Convergence arbitrage: Here, a coin bought on one exchange is sold short on another exchange. The goal is to see how both prices converge, and that’s when the arbitrageur closes both positions.
- Triangular Arbitrage: This is the most complex strategy that involves trading with more than one trading pair.
We will describe how to do each of them shortly.
Why is arbitration possible?
Do you think the whole basis of arbitration is a little strange? You’re not the only one – it’s not entirely intuitive to think of buying the same thing at two places at two different prices (or more than two).
Try to think of it this way: in economics textbooks, arbitrage is seen as a way to make markets efficient. The argument is that when markets are inefficient, people will arbitrate until prices finally stabilize and become uniform.
The fact that many people can consistently enjoy the benefits of arbitrage really makes you question this, but it’s a good idea.
So why, in a world where we must have “perfect information” thanks to the Internet, why is crypto arbitrage still possible? Here are some possible explanations:
- Liquidity Variations: Each exchange has a different amount of liquidity for each asset, depending on how many people are buying or selling it. This will naturally vary between exchanges, resulting in different prices (higher prices when liquidity is limited).
- Various types of exchange. Not all exchanges selling cryptocurrency are the same – many target different types of investors or different countries, which can affect prices.
- Time of withdrawal and deposit. Exchanges with slower processing times take longer to catch up with general market rates (often smaller exchanges).
- Currency rates. If you are really smart, you can even make a profit by buying a cryptocurrency at one exchange rate and selling it at another, which will allow you to make a profit if it is relatively cheaper in one currency.
Don’t worry if this doesn’t make complete sense to you – you can still arbitrate.
How to arbitrate cryptocurrency
The principle of crypto arbitrage is one thing; it is quite another matter to put it into practice.
Let’s go back to what we said that there are three main types of arbitration: spatial arbitration, convergence arbitration, and triangular arbitration. There are some similarities between the methods, but each of them works a little differently, so we will look at them one by one.
As a special treat, we will also add some information about creating a trading bot.
Spatial arbitration
If you choose spatial arbitrage, you buy a cryptocurrency on one exchange, transfer it to another exchange, and then sell it on another exchange. Alternatively, you can avoid the need to transfer cryptocurrency by making purchases on both exchanges at the same time.
This is the easiest way to understand, but that doesn’t mean there is no risk.
You must be careful to leave margin of error (i.e. a reasonable difference between the price you are hoping for and what you buy / sell for) in order to maximize your chances of a winning trade. And don’t forget about withdrawal and deposit fees, slow processing times, and potential technology issues.
Also, be quick! Prices are constantly changing and adjusting to the market, so if you don’t lock in while you can, you might be missing out.
Convergence Arbitration
This type of arbitrage assumes a long / short trade. Here, the arbitrageur buys the cryptocurrency at a lower price (“long”) and simultaneously sells the cryptocurrency at an inflated price (“short”).
When two prices “meet in the middle”, you can sell long and buy back short.
If you are thinking, “But how do I know if a cryptocurrency is overpriced or underpriced?” then no, you are not a fool. This is where the problem with this method lies: it can go wrong and is inherently more risky than other strategies.
However, you don’t need to have an opinion on whether to buy a particular cryptocurrency. You just need to decide whether it will increase or decrease in value relative to others.
If you are smart, you may be aware that the market might crash, but you can still make money because you are short on one side of the trade. But only if the fall in the short trade is greater than in the long one.
Triangular arbitration
If you opt for an even more complex triangular arbitrage, you just need to perform a more complex version of the above methods by switching between three different cryptocurrencies instead of two.
The first problem you will face is the difficulty of comparing prices of three different cryptocurrencies to determine profitability. Fortunately, there is a formula that you can use with the following formula:
(amount you are trading) x first pair exchange rate / third pair exchange rate = x
If the amount x is greater than the amount you want to sell (minus the commission), you should be making a profit. But, as always, we leave the error.
How to create a crypto arbitrage bot
If you think the prospect of manually reviewing each exchange and calculating how much profit you can make after accounting for commissions sounds tedious at worst or impossible at worst, we have good news.
Instead of doing the work yourself, you can create a trading bot that does it for you (but unfortunately, if you are not a developer, it will probably be even more difficult for you).
Crypto arbitrage bots use APIs (software that connect different computer programs) to track various exchanges and automatically alert when prices reach desired levels. To do this, you need to find an API for each exchange (or for a crypto tracker like CoinGecko if you want to track multiple exchanges) and then execute the program using your programming language of choice (usually Python or Javascript).
You can also find a cryptobot made by someone else if you don’t feel the need to customize it yourself, which means you only need a fundamental understanding of how to use programming languages.
To find out more, we recommend that you check out this detailed guide to setting up a trading bot.
Is Crypto Arbitrage Profitable?
Cryptocurrency arbitrage can certainly be profitable. As long as there is a difference in prices (and there certainly is), you can make money.
But that doesn’t necessarily mean that this is an easy or right choice for you. Here are a few factors to consider before you start moving at full speed.
As we have already seen, it is not only the difference in price between exchanges that matters, but also the transaction fees. This may not be that important for long-term or even short-term traders who are hoping to make big profits by timing the market, but anyone trying to arbitrate is working with small margins.
Even tiny fees can be significant, so be careful.
Plus, while arbitrage theory sounds great, the reality isn’t always that good – you never know if the exchange suddenly freezes, closes, or gets caught by technology. This is why it is so important to leave margin for error.
On the other hand, arbitrage is less risky than many other types of trading. If you buy and sell cryptocurrency on two exchanges at the same time, you may not always be making a huge profit, but generally, you will not make more than a small loss.
This makes it a great choice for those who do not want to risk long-term investments in the volatile cryptocurrency market.
Is Crypto Arbitrage Legal?
You really didn’t think that we would write an extensive article on cryptocurrency arbitrage and how to do it if it was illegal, did you? While this may sound “dodgy” to those who have never seen it before, using the price difference does not violate any laws.
Some will say that this is a good and necessary job for the markets to remain efficient and therefore fair for everyone.
However, you need to pay a little more attention to cross-border arbitration (trade between two countries) as each country has its own anti-money laundering and regulatory processes. However, this does not make it illegal – it simply means that financial institutions can take a closer look at what you are doing and you may not be able to open accounts in some countries.
Always proceed with caution.
We will rid the markets of disadvantages
No one has ever said that crypto arbitrage is a get-rich-quick scheme, but it is also not the most risky and insane trading strategy. If you understand what you are doing and only trade a very modest amount that you can afford to lose, not much can go wrong like some other cryptocurrency trading strategies.
In addition, you will also be playing a noble role in helping to eliminate mispricing in the marketplace and promoting efficiency gains. What more can you ask for?
This post was originally published on Your Money Geek.