What is arbitrage trading?
Arbitrage trading is a trading strategy that aims to generate profit by simultaneously buying an asset in a market and selling it in another. This is most commonly done between identical assets traded on different exchanges. The difference in price between these financial instruments should, in theory, be zero since they’re quite literally the same asset.
The challenge an arbitrage trader, or arbitrageur, has is not only finding these pricing differences but also being able to trade them quickly. Since other arbitrage traders are likely to see this difference in price (the spread) as well, the window of profitability usually closes very fast.
On top of that, since arbitrage trades are generally low-risk, the returns are generally low. That means arbitrage traders not only need to act quickly, but they need a lot of capital to make it worth it.
Types of arbitrage trading
There are many types of arbitrage strategies that traders all over the world in many different markets take advantage of. However, when it comes to cryptocurrency traders, there are some distinct types that are quite commonly used.
Exchange arbitrage
The most common type of arbitrage trading is exchange arbitrage, which is when a trader buys the same crypto asset in one exchange and sells it in another.
The price of cryptocurrencies can change quickly. If you take a look at the order books for the same asset on different exchanges, you’ll find that the prices are almost never exactly the same at exactly the same time. This is where arbitrage traders come in. They try to exploit these small differences for profit. This, in turn, makes the underlying market more efficient since the price stays in a relatively contained range on different trading venues. In this sense, market inefficiencies can mean opportunity.
How does this work in practice? Let’s say there’s a price difference for Bitcoin between MoonXBT and another exchange. If an arbitrage trader sees this, they would want to buy Bitcoin on the exchange at a lower price and sell it on the exchange at a higher price. Of course, the timing and execution would be crucial. Bitcoin is a relatively mature market, and exchange arbitrage opportunities tend to have a very small window of opportunity.
Funding rate arbitrage
Another common type of arbitrage trading for crypto derivatives traders is funding rate arbitrage. This is when a trader buys a cryptocurrency and hedges its price movement with a futures contract in the same cryptocurrency that has a funding rate lower than the cost of purchasing the cryptocurrency. The cost, in this case, means any fees that the position may incur.
Let’s say you own some Ethereum. Now you might be happy with that investment, but the price of Ethereum is going to fluctuate a lot. So you decide to hedge your price exposure by selling a futures contract (shorting) for the same value as your Ethereum investment. Let’s say the funding rate for that contract pays you 2%. That would mean you’d get 2% for owning Ethereum without any price risk, resulting in a profitable arbitrage opportunity.
Triangular arbitrage
Another very common type of arbitrage trading in the cryptocurrency world is triangular arbitrage. This type of arbitrage is when a trader notices a price discrepancy between three different cryptocurrencies and exchanges them for one another in a kind of loop.
The idea behind triangular arbitrage comes from trying to take advantage of a cross-currency price difference (like BTC/ETH). For example, you could buy Bitcoin with your LTC, then buy Ethereum with your Bitcoin, and finally buy back LTC with Ethereum. If the relative value between Ethereum and Bitcoin doesn’t match the value each of those currencies has with LTC, an arbitrage opportunity exists.
Risks associated with arbitrage trading
While arbitrage trading is considered relatively low-risk, that doesn’t mean it’s zero. Without risk, there’d be no reward, and arbitrage trading is certainly no exception.
The biggest risk associated with arbitrage trading is execution risk. This happens when the spread between prices closes before you’re able to finalize the trade, resulting in zero or negative returns. This could be due to slippage, slow execution, abnormally high transaction costs, a sudden spike in volatility, etc.
Another major risk when engaging in arbitrage trading is liquidity risk. This happens when there isn’t enough liquidity for you to get in and out of the markets you need to trade to complete your arbitrage. If you’re trading using leveraged instruments, like futures contracts, it’s also possible that you could get hit with a margin call if the trade goes against you. As usual, exercising proper risk management is crucial.