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Low risk and instant profit? Here comes crypto arbitrage!
The crypto market has always been criticized for its volatile nature. But did you know that you could actually use this instability to your advantage and make money off it? What’s more, you can do that without taking an actual position in the market! Sounds appealing, right? This is possible with crypto arbitrage trading, which we discuss in detail in this tutorial.
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To understand what cryptocurrency arbitrage is, we are first introducing the concept of arbitrage. Imagine that you’ve just bought a pencil for $10, which you then sold to someone else for $11. You would make a profit of $1 by simply trading it for a higher price. This model of trading is known as arbitrage.
Arbitrage is a technical term given to the old basic practice of buying a product for a lesser price and selling it for a higher price. It’s different from regular crypto trading, as you have to wait for the price of the product to rise in the future with regular trading, yet with arbitrage, you simply sell the product where it is already valued at a higher price.
For a number of reasons, the price of a crypto coin is not always the same on different exchanges. This allows you to buy a coin at a cheaper price from one exchange and instantly sell it for a higher price on another exchange: a process known as cryptocurrency arbitrage.
In crypto markets, traders use arbitrage opportunities by buying and selling crypto assets on various exchanges to profit from different prices for the same asset.
Also read:7 Ways to Earn Free Cryptocurrencies
Various factors influence the differences in crypto exchange prices. The most common factors are:
Let’s discuss these factors in detail.
The value of virtual currencies is based primarily on the trade volume, which is the cornerstone of crypto arbitrage and the primary reason for variable prices on various exchanges.
Cryptocurrency is not tied to fiat money, such as the US Dollar or the Euro, nor is it associated with any one nation or exchange in particular. As with other commodities, supply and demand for cryptocurrencies like Bitcoin vary based on the market and the time you decide to make a purchase or sale.
The core principle of trading on centralized exchanges is that the latest bid-ask paired request on the exchange order book determines how much an asset will cost.
Simply put, the real-time price of an asset on a centralized exchange is determined by the price at which it was traded most recently. Since the prices at which Bitcoin is purchased on an exchange can be different from one exchange to another, the price of Bitcoin also varies slightly on every platform.
Decentralized exchanges operate in a diametrically opposite manner, where the goal is to make the prices similar to the ones shown across other exchanges. Therefore, this system relies on crypto arbitrage traders to stabilize the price of a digital currency.
Decentralized exchanges use liquidity pools instead of an order book system where crypto assets are traded at a certain price. Every crypto trading pool is unique. Therefore, if someone wanted to trade Bitcoin (BTC) for Ethereum (ETH), they would need to search for a BTC/ETH liquidity pool on the exchange.
Each pool relies on funds from generous contributors who introduce their crypto assets to serve as liquidity in exchange for a specified share of the pool’s transaction fee. In reputable decentralized exchanges, the value of these crypto assets is regulated through a mathematical formula that keeps the pool’s asset ratio steady.
Let’s go through some of the most common, viable crypto arbitrage trading strategies.
Simple arbitrage is among the most convenient and feasible trading strategies. It involves buying crypto on one exchange at a lower price and selling it on another for a slightly elevated price to generate profit. As it is fairly low risk and easy to execute, other arbitragers can take advantage of the same opportunity.
The decentralized arbitrage strategy relies on using smart contracts to determine the price of crypto trading pairs. If these pairs’ prices on decentralized exchanges (DEXs) diverge noticeably from those on centralized exchanges, crypto arbitragers can take advantage of this situation to conduct cross-exchange transactions for profit.
Traders can use DEX to set up trading pools between any two cryptocurrencies. By using three distinct trading pools, a trader can swap currency X for currency Y, then Y for currency Z, and lastly, Z for X.
There is an arbitrage opportunity, as the exchange rates for each trading pool are independent. Also, the three changeable currency rates aren’t perfectly synced together. Overall, decentralized arbitrage is very similar to simple arbitrage except for where it’s limited to decentralized exchanges and smart contracts.
Also read:What Is DeFi And How Does It Work
Triangular arbitrage involves shifting money across three or more digital assets on a single exchange to profit from the difference in price between one or two cryptocurrencies. For instance, an arbitrage opportunity exists when the BTC/DAI pair is trading at 40,000 DAI, and one ETH equals 3,000 DAI, but the BTC/ETH pair is inefficiently priced at 40 ETH instead of 35 ETH.
Moving on, you can follow a simple strategy. Firstly, deposit funds to the exchange and purchase 1 BTC for 40,000 DAI, then trade the BTC/ETH pair to convert the BTC into 40 ETH. Finally, sell the 40 ETH for 50,000 DAI.
At the end of the process, you could make 10,000 DAI in profit on three transactions with a 20% ROI. However, for this strategy to work, it’s very important to seize this rare chance immediately before the exchange’s algorithm promptly fills the price gaps.
Let’s say Elon Musk or another influential person in the crypto market announces plans to dive into the NFT sector. The next thing we know the price of NFT project coins will start pumping hard.
If you’re going to apply the statistical arbitrage strategy, you’ll have to pick a pair of NFT coins with a strong correlation and very similar fundamentals, like $MANA and $SAND.
To select these pairs, automated systems run a check based on a number of leading indicators, like volume and even price action, then the trending coins are ranked based on these scores, and those that rank the lowest are bought, while those that rank on top are shorted.
If you notice that one of these coins is outperforming the other, you’ll need to buy the lower-valued coin in the hope that it will rise to the level of its outperforming partner while also shorting the ascending coin. Lastly, you need to wait for the prices to fluctuate again so that the two prices converge, and you can make a profit from the following reversal.
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Crypto arbitrage traders are usually novice investors looking for quick short-term profits without caring about market conditions. They differ significantly from day traders, who rely on accurately predicting crypto prices. The conventional methods of generating profit from crypto trades are complicated and require adequate experience and a maturation period.
Conversely, cryptocurrency arbitragers profit from the chance to make money by utilizing market price disparities. This is a safer and more reliable method, as it doesn’t rely on predictive pricing strategies or analyzing market sentiments.
Apart from being a low-risk strategy, there are other reasons why you may want to consider arbitrage trading:
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Just as with other forms of investment, arbitrage trading has its fair share of drawbacks:
Also read:How to Make Your First NFT
Crypto arbitrage can be made more reliable and profitable with bots, but you will need to weigh the cost of the bot against the risk it entails and the time required to monitor it. Bots can make arbitrage trading more practical for you, but you don’t need one to use the strategy. Manual crypto arbitrage trading is still possible. However, if you wish to get a bot, your best options are:
Crypto arbitrage is perfectly legal in most parts of the world, as it contributes to market efficiency and helps endorse price equalization. Use Wikipedia to check the levied taxes and legality of the crypto trade for your country.
You can compare crypto prices on a crypto arbitrage scanner website. Crypto arbitrage scanners find a coin’s minimum and maximum prices by comparing rates on several exchanges, then display those figures to the trader. You can find reputable exchanges with high rates where you can sell your coin with the help of a competent crypto arbitrage scanner. Popular options include CoinMarketCap, TradingView, and Yahoo! Finance. If you are a manual trader, check out our article about the best crypto screener websites for helpful resources.
Image credit: Infrarate via Unsplash. All screenshots by Ojash Yadav.
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