What is Arbitrage?
Arbitrage is a method of trading that aims to make a profit from differences in price of an asset on multiple markets. This is achieved by simultaneously buying and selling the same asset, taking advantage of a lower price in one market and selling it at a higher price in another. The profit is calculated by multiplying the difference in price by the quantity of assets traded.
Market price disparities usually only persist for brief periods, often during periods of high market volatility. These imbalances can vanish quickly, making it challenging for human traders to take advantage of arbitrage opportunities. To overcome this challenge, many traders use trading bots that are designed to quickly identify and capitalize on these opportunities, faster than any human trader could.
What sets this strategy apart is the speed at which profits can be realized. In contrast to most trading strategies, which require the price to move after a buy or sell order, the profit from arbitrage is achieved immediately once both the buy and sell orders are executed simultaneously. The majority of a trader’s time in this strategy is spent on preparation and monitoring for potential opportunities.
There are two main types of arbitrage trading, which are explained in depth later on:
Spatial Arbitrage: The practice of simultaneously buying and selling the same asset on two or more exchanges. This method involves buying the asset on one exchange and selling it on another, with the aim of generating profit in the form of the quote currency of the respective markets. Spatial arbitrage is the most prevalent form of arbitrage and is the main focus of this guide.
Triangular Arbitrage: A type of arbitrage that occurs within a single exchange, also known as cross-currency arbitrage. In this approach, the arbitrage requires three assets: the primary arbitrage asset, a secondary arbitrage asset, and a third asset which serves as the source of profit.
What is Crypto Arbitrage?
Crypto Arbitrage refers to a trading strategy aimed at profiting from price differences of a cryptocurrency in multiple markets or exchanges. Similar to traditional arbitrage, the trader buys the crypto at a lower price on one exchange and sells it at a higher price on another. The key difference between crypto and traditional arbitrage is the type of asset being traded.
Crypto arbitrage opportunities are fleeting, but cryptocurrencies tend to be more volatile than traditional assets, presenting more opportunities. manual execution of crypto arbitrage trades is often too slow, hence traders resort to using arbitrage trading bots in the crypto markets.
Due to the small differences in price for the same asset, traders looking to profit from crypto arbitrage must trade large quantities quickly. This requires having accounts on multiple exchanges, having sufficient funds in each, and accounting for fees related to trading and deposits/withdrawals before acting on an opportunity. The cost to entry for this strategy is high, but it has the potential to be highly profitable for a skilled trader or programmer.
How to find crypto arbitrage opportunities
Crypto arbitrage opportunities can be identified in the order book, particularly at the top of the order books of two different markets.
An arbitrage opportunity arises when the best bid price in one exchange is higher than the best ask price in another exchange. When buying a cryptocurrency at market price, the buy order matches the ask (sell) side of the order book. Conversely, when selling a cryptocurrency at market price, the sell order matches the bid (buy) side of the order book. In a single market, it is impossible for a bid price to be higher than an ask price without the orders matching and executing a trade, which is why basic arbitrage requires two or more exchanges.
To find a crypto arbitrage opportunity, traders must monitor multiple markets for the same currency pair. Spotting opportunities can be practiced even before sending funds to an exchange.
When selecting assets and markets to watch, there are important factors to consider.
- 1.Pick assets that have multiple markets — either on multiple exchanges, or the same exchange with different quote currencies.
- 2.If watching two or more different exchanges, make sure you are eligible to sign up to and fund each exchange. If you can’t trade on the exchange, the arbitrage opportunities are meaningless.
- 3.Choose markets that are highly liquid — arbitrage trading involves buying and selling at market price, so it’s essential that the markets have sizable order books to protect against slippage.
If the criteria are met, most cryptocurrencies with high market capitalization can offer arbitrage opportunities. Bitcoin and Ethereum are popular choices for crypto arbitrage as they are widely utilized, have active markets on various exchanges, and frequently exhibit high volatility.
Example of a crypto arbitrage opportunity
The image below uses Cryptowatch Desktop to compare the order books of two markets: Kraken: BTC/USD and Coinbase Pro: BTC/USD. The similar asset between both is Bitcoin (BTC):
To spot a crypto arbitrage opportunity, observe the highest bid (indicated by topmost prices in green) and lowest ask (indicated by lowest prices in red) in the markets. In this scenario, you can purchase one bitcoin from Kraken at $19,136.30, and sell it on Coinbase Pro for $19,162.16. Keep in mind that your buy order will match the ask side (represented in red), and your sell order will match the bid side (represented in green).
Check the rightmost column in the order books to view the total volume of pending orders. On Kraken, 1.1773 BTC can be bought for $19,136.30. But, selling this amount on Coinbase Pro will deplete orders in the order book until the price becomes equal, thus decreasing your earnings. There’s only a limited volume that will allow this arbitrage trade to be profitable at Coinbase Pro’s BTC price.
Determining the favorable volume for this trade involves counting the rows in the Coinbase Pro order book until the price matches the buying price of $19,136.3. If the price remains favorable after counting five rows down, then examine the volume of orders up to that level using the rightmost column of the order book. For instance, the line starting with the price “19,140.00” reveals that 0.95818 BTC can be sold before the price equalizes.
Manual execution of arbitraging can be difficult because order books often change quickly. The opportunity in the example above between Kraken and Coinbase Pro disappeared quickly after taking the screenshot. This is why most arbitrage traders rely on software to identify, calculate, and execute arbitrage opportunities.
How to profit from crypto arbitrage
In crypto arbitrage trading, the fees charged by exchanges play a crucial role in determining your profits. Market orders, which match to the top of the order book instantly, are commonly used in arbitrage trading due to their speed. However, these orders also reduce market liquidity and attract higher fees than limit orders. To make your arbitrage trading feasible, calculate a minimum profit margin taking into consideration the trading fees charged by exchanges.
When it comes to crypto arbitrage trading, it’s important to take into account the costs involved, including deposit and withdrawal fees. To minimize these costs, having funds already in place on both exchanges you plan to trade on can help. The biggest cost to arbitrage trading is often time, as purchasing an asset on one exchange, withdrawing it, and depositing it on another exchange to sell can be time-consuming and result in missed opportunities. Direct transfers between exchanges may not be feasible due to verification times needed for certain cryptocurrency transfers.
Having funds pre-deposited on the exchanges you plan to trade on is crucial to make crypto arbitrage trading efficient. This way, you can minimize the time and fees associated with deposits and withdrawals, ensuring a smoother and more profitable trading experience.
Is arbitrage trading legal?
Arbitrage, including crypto arbitrage, is considered legal and even encouraged in most countries. The reason is that arbitrage promotes market efficiency and price equalization, which is achieved by traders who take advantage of the price differences in various markets. This strategy has been around for a long time and has a rich history, with early forms of arbitrage dating back before recorded history. Merchants used to gather information from travelers and other traders about high-demand goods abroad and then purchase them in places where they were readily available and cheap. By selling the goods in places where demand was high, they could reap a profit. This early form of arbitrage is similar to what traders do today in cryptocurrency markets. The Silk Road, for example, was a trade route where goods like silk were produced in East Asia and then traveled west to reach the Mediterranean and eventually Europe. In the Western world, silk products were rare and highly valued, making them more expensive than in the places where they were produced. Merchants who bought silk in the East and sold it for a profit in the West were historical arbitrageurs. The rise of online trading, particularly in cryptocurrency markets, has made it easier for traders to implement arbitrage strategies.
How spatial arbitrage trading works
Buying and selling simultaneously in two different exchanges is called spatial arbitrage. This is the most commonly-known form of arbitrage and the primary subject of this Guide. The example given above comparing Kraken and Coinbase Pro’s BTC/USD markets is an example of spatial arbitrage.
Spatial arbitrage is essentially a 2-step process:
- 1.Buy an asset in Market 1 for a low price
- 2.Sell the asset in Market 2 for a higher price
You can transfer the asset after purchasing it in step one, or fund Market 1 with fiat currency and Market 2 with the asset you intend to arbitrage. Transferring it, as mentioned above, is often too inefficient to capture an opportunity before it disappears.
How Triangular Arbitrage trading works
Triangular arbitrage, also known as cross-currency arbitrage, involves buying and selling of three different currencies on a single exchange. This type of arbitrage requires calculating the exchange rate between two quote currencies to identify profitable opportunities, which can be more complex compared to spatial arbitrage.
Cryptowatch simplifies cross-currency arbitrage by allowing you to select the fiat currency in which a market’s prices are displayed. To change the quote currency, go to the settings menu in the top right corner of the Charts page. Note that this only affects the visual representation and the actual quote currency will be obtained when making a sale in the market.
Triangular arbitrage uses three assets and three currency pairs in its process. Here’s an example using USD, Chainlink (LINK) and Ethereum (ETH):
- 1.Deposit USD and use it to buy LINK in LINK/USD
- 2.Open LINK/ETH and change the quote price to USD in the trade settings menu
- 3.Buy LINK in LINK/USD when the best bid price is higher than the best ask price in LINK/ETH
- 4.Sell LINK in LINK/ETH immediately after buying in LINK/USD
- 5.Sell ETH in ETH/USD when you want to realize profit
Instead of buying and selling in the same currency pair on two different exchanges (spatial arbitrage), this method involves buying in one currency pair and selling in another. Both currency pairs share a base currency and have differing quote currencies.
After completing steps 1 and 2 you are set up to repeat steps 3 and 4 as often as you like, or as often as arbitrage opportunities are appearing. Triangular arbitrage nearly eliminates withdrawal fees as a cost, but exposes you to two cryptocurrencies in the process. This carries a heightened level of risk, so make sure to practice good risk management if you choose to carry out this (or any) trading strategy.
Build an Arbitrage dashboard in Cryptowatch Desktop
Cryptowatch Desktop is Cryptowatch’s native app — it’s super fast and runs right on your desktop, streaming crypto data in real-time. What arbitrageurs will find most useful in Cryptowatch Desktop is the ability to run multiple market feeds on a single screen.
Here’s an example of a dashboard we’ve created to watch for Stellar (XLM) arbitrage opportunities:
This dashboard divides each exchange into its own column, identified at the top using the Text module.
The Ticker module in the second row is crucial as it displays the latest traded price along with the top of the order book. This row makes it convenient to determine if the bids in any of the markets are higher than the ask of another market.
The third row showcases the order books of each market, giving us a glimpse into the volume assigned to orders near the top of the order book, helping us to determine the amount of trade volume required before arbitrage becomes unprofitable.
The final row features Tick Charts for all the markets, which depict the bid-ask spread over time in a graphical format. This allows us to track the direction of either the bid or ask side of the order book and identify any trends.
Is crypto arbitrage trading viable?
As long as markets are not perfect, arbitrage trading will remain a viable option for many investors. The existence of price imbalances between exchanges and comparable markets are still being equalized due to the actions of arbitrage traders.
Crypto arbitrage is not a strategy suited for novice traders, as it requires significant capital to generate worthwhile profits. Due to the small size of price discrepancies, trading in large volumes is necessary for efficient profits. If you opt for manual trading, crypto arbitrage demands close monitoring of the markets, consuming a substantial amount of time. On the bright side, profits can be quickly realized once an arbitrage opportunity arises, eliminating any waiting time.
Triangular arbitrage eliminates the costs of repeated withdrawals and deposits, although it adds an extra layer of complexity to the strategy.
Arbitrage trading can be a profitable strategy if you have the financial resources, the necessary skills, and the discipline to master the technique.