Cryptocurrency markets, just like traditional financial markets, present numerous opportunities for savvy investors to profit. One such strategy, known as crypto arbitrage trading, has gained considerable attention due to its potential for generating substantial returns. However, crypto arbitrage trading (and actually arbitrage trading in general) is often considered as somehow mystic and super complex.
In this article, we’ll dive into the concept of crypto arbitrage trading, the various types of arbitrage strategies, and the risks and rewards associated with this unique approach. Moreover, we will show you that crypto arbitrage trading hasn’t to be complex but holds juicy profit potentials when executed correctly. So let’s get right into it!
Understanding Crypto Arbitrage Trading
Let’s start with the basic and take a definition: “Crypto arbitrage trading capitalizes on price discrepancies between different cryptocurrency exchanges.”
And here’s the interesting part: Since the cryptocurrency market is relatively new and often volatile, these discrepancies can be significant, allowing traders to buy low on one exchange and sell high on another, thereby earning a profit.
This strategy leverages the decentralized nature of the cryptocurrency market, where multiple exchanges offer varying liquidity levels and pricing. However, there are more strategies than utilizing two exchanges. Here are some of the most common and profitable crypto arbitrage strategies:
Simple Crypto Arbitrage
As mentioned, this is the most basic arbitrage strategy. This strategy involves purchasing a cryptocurrency at a lower price on one exchange and selling it at a higher price on another.
Example:
Suppose the price of Bitcoin (BTC) on Binance is $40,000, while on MEXC, it’s trading at $40,500. A trader could buy BTC on Binance and immediately sell it on MEXC, making a profit of $500 per BTC, minus fees. Simple arbitrage requires quick execution, as price discrepancies can vanish rapidly.
Pre-Requisite
However, there’s one important aspect to consider. This strategy only works, if the trader holds the tokens on MEXC before executing the strategy. The process of buying on Binance, withdrawing and adding to MEXC, and then selling there is simply to long. Accordingly, the likeliness that the price changes is very high.
Therefore, this strategy requires an initial invest since you have to buy every token you want to arbitrage on at least two exchanges. Consequently, this leads to the fact that the strategy is not perfectly suited for private investors.
Triangular Crypto Arbitrage
This method involves trading three (or more) different cryptocurrencies within the same exchange. For instance, a trader might start with Ethereum (ETH) on Binance and notice price imbalances between ETH/BTC, BTC/LTC, and LTC/ETH trading pairs. The trader first trades ETH for BTC, then BTC for Litecoin (LTC), and finally LTC back to ETH, aiming to capitalize on the price imbalances and end up with more ETH than initially held.
Accordingly, a triangular arbitrage trade ends with the same token it started. However, the amount is (or at least should be) higher compared to the start.
Pro’s and Con’s
Compared to the Simple Crypto Arbitrage, Triangular Crypto Arbitrage has the huge advantage that you don’t have to hold any tokens prior to executing the strategy. Whenever you spot a arbitrage opportunity you can start buying the required tokens. Looking at the above example, you don’t have to hold ETH before you spot the opportunity. In fact, you can simply buy ETH, execute the strategy and ultimately sell your ETH for USD.
However, there’s one huge disadvantage of this strategy: It is rather complex to spot opportunities. In fact you require smart tools that constantly monitor prices and calculate potential arbitrage routes.
DEX-CEX Arbitrage:
This strategy is basically just a specific form of the Simple Crypto Arbitrage. However, we found it important to list it separately since it is often overseen — although the profit potential can be huge.
This strategy focuses on exploiting price differences between decentralized exchanges (Binance, Kucoin, etc.) and centralized exchanges (Uniswap, PancakeSwap, etc.).
The arbitrage process is pretyy much the same as described above. For example, a trader might notice that BTC is trading at $40,000 on a CEX like Binance, while on a DEX like Uniswap, it’s trading at $40,300. The trader could buy BTC on Binance and sell it on Uniswap for a profit of $300 per BTC, minus fees.
Derivatives-Tokens Arbitrage
This type of arbitrage involves capitalizing on price differences between a cryptocurrency’s derivative product, such as a perpetual swap contract, and the underlying token itself.
For instance, suppose the price of a Bitcoin perpetual swap contract on a derivatives exchange like FTX is $50,000, while the current spot price of BTC on Binance is $49,900. A trader could simultaneously buy BTC on Binance (the underlying asset) and sell an equivalent amount of the BTC perpetual swap on FTX (the derivative).
As the perpetual swap price eventually converges with the spot price, the trader could close both positions, profiting from the price difference. This strategy is commonly referred to as “cash and carry” arbitrage.
Pro’s & Con’s
Personally, this is one of my favourite arbitrage strategies. Similar to the second strategy it does not require you to hold any assets before executing trades. On top of that, the process of identifying arbitrage opportunities is much easier compared to triangular trades. And third, you could also focus on exchange only.
Nevertheless, it’s essential to consider factors such as fees, funding rates, and the cost of holding the underlying asset when executing these trades.
Risks Associated with Crypto Arbitrage Trading
While crypto arbitrage trading can offer substantial profit potential, it also comes with inherent risks:
Execution Risk
Rapid price fluctuations can make it difficult for traders to execute their arbitrage strategies quickly enough to capitalize on price differences.
Exchange Risk
Different exchanges may have varying levels of liquidity, which can impact the ease of buying and selling cryptocurrencies at the desired price.
Transfer Risk
Moving cryptocurrencies between exchanges can take time, and delays can lead to missed arbitrage opportunities or even losses.
Regulatory Risk
Traders must be aware of the different regulatory environments across various exchanges and jurisdictions, as these can impact the feasibility of arbitrage strategies.
Wrap-Up
Crypto arbitrage trading can be a profitable endeavor for investors who understand the nuances of the cryptocurrency market and are prepared to navigate the associated risks.
By employing various arbitrage strategies, traders can capitalize on price discrepancies to generate returns. However, it’s crucial to carefully consider the potential risks and rewards before diving into crypto arbitrage trading.