EXPLAINER: What is arbitrage trading?

As you must have noticed already, the price of cryptocurrencies such as Bitcoin (BTC) is not always the exact same across different exchanges. Taking advantage of these price differences is one way to engage in arbitrage trading.

Simply put, arbitrage is a trading strategy that intentionally exploits market inefficiencies, and since the crypto industry is still relatively young and somewhat fragmented, ‘arbitrageurs’ are in a good position to yield considerable gains.

Of course, arbitrage trading is nothing new: it has existed in stock, bond and forex markets for many years. However, as high-frequency trading systems or sophisticated trade-bots have been developed to detect price differences and instantly execute trades across markets, arbitrage trading has become less accessible to retail traders.

Crypto markets, however, still offer plenty of opportunities for aspiring arbitrage traders.

When it comes to crypto markets, it is quite common to see sudden surges in trading volume push the price up on certain exchanges, causing significant price differences across trading venues. Furthermore, larger exchanges with more liquidity tend to drive the price of the rest of the market, with smaller exchanges usually lagging slightly behind.

What types of arbitrage trading are there?

Actually, there are many different forms of arbitrage trading. Here we will only discuss three of the most common ones.

Simple arbitrage
In the most basic sense, this involves the purchase and immediate sale of the same coin on separate trading venues.

Quick example

You buy 10 BTC for $100,000 on Exchange A, quickly transfer your funds to another account, and then immediately sell your BTC for, say, $102,000 on Exchange B.

Triangular arbitrage
This is a bit more complicated, but it basically entails taking advantage of differences in price across currency pairs. For example, you buy BTC with USD, sell your BTC for GBP, and then exchange your GBP for USD.

Convergence arbitrage
This strategy would look something like this: you buy a coin on Exchange A, where it is undervalued, and you short-sell the same asset on Exchange B, where it is overvalued. When the two separate prices meet, you can profit from the amount of convergence.

Is arbitrage trading risk-free?

It is often said that arbitrage trading is ‘risk-free’. From a price-centric point of view, this may be true but before you jump into the art of arbitrage, you should consider the following:

• Transaction speed: It may take some time for a transaction from one exchange to another to be completed, depending on how fast your transaction is verified on the blockchain — in the worst case, once your funds arrive, price differences may no longer be significant.
• KYC: While the idea of trading across exchanges sounds simple, it’s good to bear in mind that in order to trade large volumes, many exchanges require you to go through extensive Know Your Client (KYC) verification processes.
• Exchange fees: Before engaging in any type of arbitrage trade, you will need to be fully aware of the fees involved, both for transacting funds from one exchange to another, as well as for trading on the exchange itself.
• Reputation: You must bear in mind that price differences between exchanges can in some cases be due to malpractice and market manipulation. Before transferring your funds to another exchange, you must conduct due diligence and ascertain the overall reputation of that exchange.

Notwithstanding these critical points, arbitrage trading is something all crypto traders should be familiar with — if only because as more and more arbitrageurs pursue opportunities born from price differences, prices are effectively made to converge which contributes to market health and efficiency.

Originally published at https://academy.aax.com on August 28, 2019.