Taking advantage of market price variations: arbitrage trading basics
Arbitrage trading is a form of trading which can profit the investor without actually taking on any risk. The primary objective of arbitrage trading is to take advantage of variations in the price of an asset from one market to the next, from one exchange to the other. Many times an investor will purchase an asset on one market to immediately sell it on another for a gain. Other types of arbitrage are utilised by index fund companies and sports bettors.
The idea behind arbitrage is not to buy and hold an asset as many investors do. With this type of investment strategy, an individual will purchase and sell almost simultaneously. Another important element of arbitrage is that it is considered to be risk-free.
For example, if an asset is trading for $10 US Dollars (USD) on one exchange and $10.02 USD on another, an investor could purchase it on the cheaper exchange and immediately sell it on the other exchange. In order to make a significant profit, the investor would need to purchase a large asset portfolio with this strategy. With this type of arbitrage trading the investor knows that there is little to no risk because the pricing is available in both markets when the purchase is made.
Index Fund Arbitrage
Index funds also provide ripe opportunity for traders to take advantage of arbitrage trading. An index fund is basically a portfolio of assets which mirror a financial index. When these components are removed and added to the index, the index funds are required to do the same thing. Sometimes, index fund companies will conduct thorough research prior into which companies may or may not be added to the financial index prior to the official announcement.
The index fund can then purchase the companies it believes will be included in the index in advance of the announcement. When this happens, the index fund can take advantage of an increase in the price of the stocks. This provides extra returns simply by predicting what the index will do.
Sports Betting Arbitrage
Another common form of arbitrage trading is practiced within the sports betting world. Sports arbitrage involves working with multiple sports books at the same time. Many sports books will publish different odds on sporting events. When this happens, a bettor can place bets in opposite directions at different sporting books and make a profit regardless of what happens in the game.
Arbitrage difference in the cryptocurrency market
Though the asset in question may be different, the general principle of arbitrage is the same in any market. In other words, Bitcoin arbitrage works the same as stock arbitrage, in theory.
There are, however, a few things that are specific to the cryptocurrency realm. First, volatility in the cryptocurrency space is significantly greater. This volatility can be a positive factor for arbitrage. Sharp and sudden changes can create significant disparities in price across exchanges. It is not uncommon for digital currencies to experience a 25% drop in a 24-hour period.
Additionally, the cryptocurrency market is largely unregulated with more than 200 exchanges currently operating globally. These conditions can be immensely favorable when traders can take into consideration numerous options and potentially large price disparities between exchanges.
Arbitrage in cryptocurrency is also dependent on technology. In manual arbitrage, the transaction speed of the coin can make a significant difference. Some coins arrive near instantly when sent to an exchange wallet; others can take up to 20 minutes to arrive. This should be a significant consideration for anyone seeking to manually arbitrage across two exchanges.
The basics of arbitrage strategy
There a various methods traders consider when developing an arbitrage strategy. One can choose to proceed manually (all work done by hand), with the assistance of a bot, or even a cryptocurrency arbitrage software.
To arbitrage trade cryptocurrencies manually, a trader should monitor the price of an asset across a variety of exchanges in real time, and be prepared to arbitrage once a disparity has been discovered. There are websites and applications available which assist in monitoring real time crypto prices across various exchanges.
It’s also possible to arbitrage on a single exchange by using different pairings. For example, an altcoin may be paired with Bitcoin and Ethereum, but have slightly different prices for both. If Bitcoin pairing is cheaper, a trader can buy the altcoin and immediately sell it under the Ethereum pairing.
Trading bots operate on the same arbitrage principles but have certain advantages which human traders can’t replicate.
- First, an arbitrage bot is much faster — considering speed is essential, this is a major advantage.
- Second, an arbitrage bot never needs to rest, eat, or do anything except hunt for price disparities. A cryptocurrency arbitrage bot scans for and detects gaps in prices and executes orders for a profit.
Some bots are limited to arbitrage on a single exchange; other, more powerful software programs (such as the HTS Inter-Exchange Arbitrage Bot) will detect price gaps on multiple exchanges and execute a profitable buy and sell — assuming the coin pairings are available on both platforms). HTS is one of the few platforms offering a bot which supports this trading method.
An advanced arbitrage bot can play a critical role in trading success considering its speed and endurance to maximize opportunities. To achieve optimal performance, however, it’s essential that each user configures the bot according to their circumstances and that they acknowledge any restrictions (such as the need to manually re-balance a wallet).
Traders may also supplement automated trading with manual arbitrage opportunities. In this case, studying patterns in the order books in real time can help traders identify price disparities before they occur.
Ultimately, with enough research and due diligence, a trader can develop an arbitrage strategy that delivers consistent results.
Bottom line
Arbitrage is a popular cryptocurrency trading strategy for a variety of reasons. It offers limited downside risk, it works in up, down, and sideways markets and it’s a relatively easy technique to implement.
There are some considerations, however. While the risk is limited, it still exists; if one is trading manually, it’s possible to get stuck ‘holding the bag’ if the attempt to arbitrage was not executed quick enough and the opportunity was missed. Arbitrage also requires legal and administrative work, as opening accounts at various exchanges and ensuring software is optimized can be laborious.
If done right, however, arbitrage is one of the most highly effective techniques. By using the correct set of tools, you can place yourself in the best possible position to profit.
The original story was published on the official Xena Exchange blog
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Remember that trading cryptocurrencies comes with significant risks. You may suffer considerable losses and may potentially lose more than you have invested. If the risks involved seem unclear to you, please consult an outside specialist for independent advice.
All indicators, studies, and trading signals provided on the platform are based on technical analysis and are predefined algorithms that use the history of prices, the state of the order book, and other data as input. These tools are to only be used along with thorough market analysis. No tools can guarantee future profits or predict the movement of markets with absolute precision.
