Ready to take your crypto investing to the next level and take advantage of the constant price movements? Cryptocurrency arbitrage will probably seem like an attractive prospect — who doesn’t like the idea of buying crypto in one place and selling it for a profit somewhere else?
When done successfully, cryptocurrency arbitrage can literally mean making money out of thin air. But done wrong, it can mean losing huge sums, so make sure you know what you’re doing before you dive straight in.
Keep in mind, arbitrage is unlike researching and then investing in crypto for the long term, so if you’re curious to learn more, we’ll cover what crypto arbitrage is, how to do it, and whether you’re likely to pull it off profitably.
What Is Crypto Arbitrage?
Simply put, crypto arbitrage means buying cryptocurrency on one exchange and selling it for a higher price on another exchange, allowing you to make a profit.
This process is possible because there are various crypto exchanges out there, and their prices adjust differently depending on their liquidity and how fast they change to general market prices.
For instance, if you buy one Bitcoin for $42,000 on Binance then sell it for $42,500 on Huobi, you’ve successfully netted $500. In reality, a profit this high is unlikely given most platforms take a cut, but it’s certainly possible to make something if you’re smart — we’ll explain how soon.
Arbitrage is different from other trading strategies since you’re not taking advantage of price changes over time — you’re taking advantage of price differences between exchanges.
As a side note, this phenomenon isn’t unique to cryptocurrencies. You can also do arbitrage for foreign currencies, stocks, precious metals, and other assets. People have been engaging in arbitrage for centuries!
Still, you might have an easier time with cryptocurrencies than more traditional assets since it’s a newer and less efficient market. A few big exchanges significantly impact the prices of smaller exchanges (which adapt more slowly).
Types of Arbitrage
Now you should get the basic gist. But did you know that there are a few different types of cryptocurrency arbitrage, all of which work a little differently? Yes, that’s right — just as you thought you knew it all, we’re throwing you a curveball.
Make sure you know the difference between the following –
- Spatial arbitrage:This type of arbitrage involves purchasing crypto from one exchange and immediately selling it on another for more money.
- Convergence arbitrage:Here, a coin bought on one exchange is sold short on another exchange. The goal is to see both prices converge, and which is when arbitrageur closes both positions.
- Triangular arbitrage:This is the most complicated strategy and involves trading across more than one trading pair.
We’ll outline how to do each one shortly.
Why is Arbitrage Possible?
Thinking the whole basis behind arbitrage is a little odd? You’re not the only one — it’s not exactly intuitive to think about buying the same thing in two places for two different prices (or more than two).
Try seeing it this way: Economics textbooks refer to arbitrage as a way to make markets efficient. The argument goes that when markets are inefficient, people will engage in arbitrage until prices finally regulate themselves and become uniform.
The fact that many people can take advantage of arbitrage consistently does cast some doubt on this, but it’s a nice idea.
So, in a world where we should have “perfect information” thanks to the internet, why does crypto arbitrage continue to be possible? Here are some potential explanations:
- Variations in liquidity: Every exchange has a different amount of liquidity for each asset, depending on how many people buy or sell it. This will naturally vary between exchanges, resulting in different prices (higher prices when liquidity is limited).
- Different exchange types.Not all exchanges selling cryptocurrencies are the same — many target different types of investors or different countries, which can affect prices.
- Withdrawal and deposit times.Exchanges with slower processing times take longer to catch up with the overall market rates (often smaller exchanges). Foreign exchange rates. If you’re really smart, you might even be able to generate profits by buying crypto at one exchange rate and selling it in another, allowing you to secure a profit if it’s relatively cheaper in one currency.
Don’t worry if this doesn’t make total sense to you — you can still do arbitrage.
How to Arbitrage Cryptocurrency
The principle of crypto arbitrage is one thing; putting it into practice is quite another.
Let’s rewind to when we said there are three main types of arbitrage: spatial arbitrage, convergence arbitrage, and triangular arbitrage. There are some similarities between the methods, but each one works a little differently, so we’ll go through them one by one.
As a special treat, we’ll also throw in some information about creating a trading bot.
If you opt for spatial arbitrage, you’ll buy crypto on one exchange, transfer it to another exchange, then sell it on the other exchange. Alternatively, you could avoid having to transfer your crypto by simultaneously making the purchases on both exchanges.
This is the simplest method to understand, but that doesn’t mean there’s no risk.
You’ll have to be careful to leave a margin of error (aka a reasonable difference between the price you’re hoping for and what you buy/sell for) so that you maximize your chances of making a profitable trade. And don’t forget about withdrawal and deposit fees, slow processing times, and potential technological problems.
Also, be quick! Prices are constantly changing and adjusting to the market, so if you don’t lock them in while you can, you could lose your chance.
This type of arbitrage involves a long/short trade. Here the arbitrageur buys underpriced crypto (“long”) and simultaneously sells overpriced crypto (“short”).
When the two prices “meet in the middle,” you can sell the long and buy back the short.
If you’re thinking, “but how am I supposed to know whether a crypto is overpriced or underpriced?” then no, you’re not stupid. This is precisely the problem with this method: it can go wrong and is inherently riskier than the other strategies.
However, you don’t need to have an opinion on whether a particular cryptocurrency is worth buying. You only need to decide whether it will increase or decrease in price relative to the other.
If you’re sharp, you might realize that the market can crash, but you still might make money because you’re short on one side of the trade. Only if, though, the decline on the short trade is bigger than on the long trade.
If you’re opting for the even more complicated triangular arbitrage, you’ll basically just need to do a more complex version of the above methods by transferring between three different cryptocurrencies instead of just two.
The first problem you’ll run into is the difficulty of comparing the prices of three different cryptocurrencies for profitability. Fortunately, there’s a formula you can use the following formula:
(amount you’re trading) x exchange rate of first pair / exchange rate of third pair = x
If x amount is larger than the amount you want to trade (minus fees), you should be making a profit. But as always, leave a margin of error.
How to Build a Crypto Arbitrage Bot
If you think the prospect of manually checking every exchange and calculating how much profit you can make after you account for fees sounds exhausting at worst or impossible at worst, we’ve got good news.
Instead of doing the work yourself, you can make a trading bot to do it for you (but unfortunately, if you’re not a developer, you’ll probably find this even more difficult).
Crypto arbitrage bots use APIs (software that connects different computer programs) to track different exchanges and automatically alert you when prices hit the levels you want.
You might also be able to find a crypto bot somebody else has built if you don’t feel the need to customize it yourself, which means you’ll only need a fundamental grasp of how to use programming languages.
To find out more, we recommend checking out this detailed guide for setting up a trading bot.
Is Crypto Arbitrage Profitable?
Cryptocurrency arbitrage can certainly be profitable. As long as price differences exist (which they certainly do), there will be a way to make money.
But that doesn’t necessarily mean it’s easy or the right choice for you. Here are some factors to consider before you go full speed ahead.
As we’ve seen already, it’s not just the price differentials between exchanges that matter — there are also the transaction fees. These might not be such a big deal for long-term or even short-term traders that hope to make large profits by timing the market, but anyone trying to pull off arbitrage is working with tight margins.
Even tiny fees can be significant, so watch out.
Also, although the theory of arbitrage sounds great, the reality isn’t always so pretty — you never know if an exchange will suddenly freeze, shut down, or if you’ll end up getting caught out by technology. That’s why leaving a margin for error is so important.
But on the other hand, arbitrage is less risky than many other types of trading. If you’re buying and selling the crypto on two exchanges at the exact same time, you might not always make an enormous profit, but you generally won’t make more than a slight loss either.
This makes it a great choice for anyone who doesn’t want to risk holding investments long-term in the volatile crypto market.
Is Crypto Arbitrage Legal?
You didn’t really think we’d be writing an extensive article about crypto arbitrage and how to do it if it wasn’t legal, did you? Although it might sound “dodgy” to those who have never seen it before, taking advantage of price differences doesn’t break any laws.Some would say it’s a good and necessary job to keep markets efficient and therefore fair for everyone.
However, you’ll need to take a little more care with cross-border arbitrage (trading between two countries) since each country has its anti-money laundering and regulatory processes.
This doesn’t make it illegal, though — it just means financial institutions might examine what you’re doing a little more carefully, and you might be unable to open accounts in some countries.
Always proceed carefully.
Let’s Rid the Markets of Imperfections
Nobody ever said that crypto arbitrage was a get-rich-quick scheme, but it’s also not the riskiest, craziest trading strategy out there. If you understand what you’re doing and you only trade a very moderate amount that you can afford to lose, not as much can go wrong as some other crypto trading strategies.
Besides, you’ll also be fulfilling the noble roles of helping to eliminate mispricings in the market and contributing to efficiency. What more could you ask for?
This post originally appeared on Your Money Geek.