Understanding arbitrage trading
What is arbitrage?
Arbitrage is a market trading technique with a long history. It was used to trade on the first stock market in Amsterdam. Today, it’s commonly used by High Frequency Trading (HFT) software to exploit price discrepancies across multiple markets. Use of arbitrage algorithms has migrated from stock markets to cryptocurrency exchanges, where the price is more volatile. As such, arbitrage on cryptocurrency exchanges can be viewed as more profitable than against traditional stock markets. This article looks at arbitrage trading and how it can be employment against the cryptocurrency markets of today.
Please note that no content in this article is intended as finance or trading advice.
Arbitrage trading is exploiting price discrepancies between two markets in order to make a profit.
Let’s start with a simple example. Two cryptocurrency exchanges, Exchange 1 and Exchange 2, are selling Bitcoin at different prices. Exchange 1 is selling a Bitcoin for £5,000 and Exchange 2 is selling a Bitcoin for £5,500. We can see immediately that there’s a price discrepancy of £500. In summary, buying a Bitcoin on Exchange 1 and selling it on Exchange 2 would result in £500 profit. Easy money…
We could express this as:
Potential profit = Price on Exchange 2 - Price on Exchange 1
If only it was so simple! Unfortunately, real world examples are a bit more complex. When calculating opportunities, there are additional costs that need to be factored into the algorithm. These include:
- Maker Fees
- Taker Fees
- Transactions Fees
- Cost of Lost Opportunity
- Small currency quantities
Maker & Taker Fees
When buying or selling cryptocurrencies most exchanges will leverage a fee on the order. Maker-Taker is a widely used fee structure, where different levels of fees are applied depending on whether an order is adding liquidity, or removing it, from the market. For those trading low volumes of cryptocurrencies, these fees generally range from 0.1–0.3% of the order amount. When calculating arbitrage opportunities across different exchanges, it’s important to know that the fee will be applied by each exchange, and that the fee structure for each exchange may vary.
As it stands, are algorithm evolves to become:
Potential profit = Price on Exchange 2 - Price on Exchange 1 - Exchange 1 Fee - Exchange 2 Fee
The price of cryptocurrency transactions can vary dramatically. During 2017 the Bitcoin network was unable to cope adequately with high demand. This resulted in long waits for confirmations and high cost for transactions. Transaction fees today are significantly lower that the highs of around $36 dollars that were seen in 2017. High transactions fees quickly erode arbitrage opportunities across exchanges.
Joseph Poon and Tadge Dryja, two developers of the Lightning Protocol, suggested in a tech talk that transaction fees on the lightning are going to be very low. Low cost, fast transaction fees are important for this method of arbitrage to remain profitable. This is true for any currencies transfers between exchanges as part of an arbitrage opportunity.
Potential profit = Price on Exchange 2 - Price on Exchange 1 - Exchange 1 Fee - Exchange 2 Fee - Transaction Fees
Cross exchange arbitrage incurs transfer fees. This has two distinct disadvantages:
- Continuous fees erode profit and;
- The time it takes for cryptocurrency transactions to confirm removes our ability to execute new or alternative trading opportunities.
As such, a simple Arbitrage strategy can be ineffective at maximising market opportunities, being too slow to result in any significant profit generation.
Settling buy and sell orders for every arbitrage opportunity is both time consuming and expensive. The utility of a cryptocurrency is unavailable while the transaction is being confirmed .Additionally, excessive transfers will erode the profitability. A more effective strategy is to maintain a float balance in multiple exchanges.
This allows us to place buy and sell orders near simultaneous, which in turn reduces the chance of the price discrepancy normalising. As such, the increase/decrease of the asset pair on that exchange changes in value faster than on the second exchange. If the reduction/increase in price is quite rapid, the opportunity may be open for an extended period of time. This may be several minutes, but can occasionally run to hours or days, though at arbitor.io we’ve observed this to be the exception rather than the rule.
The diagram above shows that the price of cryptocurrency pairs are volatile.
Triangular Arbitrage is just an extension of normal arbitrage, with the exception that it’s particularly more effective when executed on a single exchange. Rather than looking for opportunities across two currency pairs, triangular arbitrage is looking for opportunities across three currency pairs.
For example, if Bitcoin is our base currency, it’s not uncommon that we can increase of volume of Bitcoin we converting our Bitcoin to Ethereum, our Ethereum to Litecoin, and our Litecoin to Bitcoin. Providing that the exchange rates between the separate currency pairs is favourable, we can end up with more Bitcoin than we had initially.
Consider the following exchange rates:
1BTC / 29.93 Ether
1BTC / 112.25 Litecoin
1ETH / 3.94 Litecoin
Using the above figures we can see that our Bitcoin converted to Ether would give us 29.93 Ether. Converting this to Litecoin, we would receive 117.9242 Litecoin. Converting this back to Bitcoin from Litecoin we would receive ~1.0505 BTC. A theoretical profit of around 0.0505 Bitcoin. Importantly, this example omits the fees leverages by the exchange for the sake of simplicity.
1BTC / 29.93 Ether = 29.93 Ether
29.93 Ether - 0.10% Fees (2.993) = 26.937 Ether
1ETH / 3.94 Litecoin = 106.13178 Litecoin
106.13178 Litecoin - 0.10% Fees (10.613178) = 95.518602 Litecoin
1BTC / 112.25 Litecoin = ~0.850945 Bitcoin
As we can see in the example above, when taking into account exchange fees, we would actually lose value from the above trade.
The advantage of triangular arbitrage is that the settlement currency ends up back at where you started. If you started with Bitcoin and the opportunity executes successfully, you’ll end up with your valuation back Bitcoin. This can be advantageous when executing opportunities against low market cap altcoins. While they tend to fluctuate quickly in price but have less intrinsic value that some of the bigger cryptocurrencies.
While viewed as a relatively safe trading strategy, arbitrage operates on thin margins. This means that unexpected changes could dramatically reduce the profitability of the strategy. For example, changes to exchange fee structures or increased transaction fees may render the technique unprofitable and result in a net loss. This risk is derived from the use of exchanges for trading, rather than arbitrage as a trading strategy. Mitigating this risk can be achieved through a general awareness of the exchange fee landscape, and dynamic fee detection that can be built into automated trading tools.
While arbitrage aims to profit from discrepancies across exchanges, it provides liquidity to the market and helps ensure that prices remain proportionately consistent across exchanges. This provides confidence as to the current value of a Bitcoin, which is important for Bitcoin markets.
Arbitrage can be viewed as a lower risk strategy that looks to consolidate profits quickly and in small amounts, rather than holding out against bigger gains or loses. This will appeal to some people, and won’t to others. Arbitrage is a trading technique with a long history, and it’s likely to be around for a while yet.
Have any thoughts or experience using an arbitrage trading strategy? Let us know in the comments below.