By James Davis
In the crypto world, finding a token priced differently in various exchanges is possible. Therefore, some traders may decide to buy the crypto asset where it’s priced low and sell it on another exchange for a higher price. The act of taking advantage of the price difference is called crypto arbitrage.
For example, a trader may realize that BTC is priced at $20,000 on Coinbase while trading for $20,800 on Binance. To exploit the difference, the trader buys Bitcoin on Coinbase and immediately sells it on Binance, making a profit of about $800.
Note that if you are to realize any profit, you must be super quick because these price variances do not last long. Arbitrage traders who have mastered the art of timing the market correctly generate immense profits.
How Do Crypto Prices Work?
How do cryptocurrencies get their values? A group of critics has argued that any value assigned to a non-backed crypto asset is nothing but speculative. On the other hand, crypto enthusiasts say the price at which people are prepared to pay for a coin can be considered its value. It’s fair to say there is truth in both arguments.
On centralized exchanges, the prices of cryptocurrencies are dictated in order books, which contain sell and buy orders at varying prices. For instance, a trader could place a buy order for one BTC at $35,000. This order goes on the order book and is fulfilled by another trader who wishes to sell their BTC for the same price.
Crypto exchanges usually price a coin based on the latest trade. Taking the previous example, suppose the latest completed trade saw BTC change hands for $35,000, then the trading platform would set its price at $35,000. Most exchanges price crypto assets this way, although some rely on other crypto exchanges to set their own prices.
What are the different types of Arbitrage?
Between Exchanges
The most popular crypto arbitrage method involves buying a token on one exchange and transferring it to another where it’s priced higher. But there are several issues that come with this method. For example, as mentioned earlier, price differences do not last long. Therefore, it is possible to make losses because transferring crypto assets from one exchange to another can take several minutes. On top of that, transaction fees are another problem, as moving cryptocurrencies between exchanges incurs charges which can significantly eat up traders’ profits.
One way for arbitrage traders to avoid such fees is by holding a crypto asset on two different trading platforms. A trader who has adopted this method is able to purchase and sell a coin simultaneously. Here is how to do it: For instance, a trader might be holding $35,000 in USDT stablecoin on Coinbase and one BTC on Binance. When BTC is priced at $35,500 on Binance but only $35,000 on Coinbase, the trader can use their USDT to purchase Bitcoin on Coinbase and sell the BTC they hold on Binance. This way, the trader would make a $500 profit without losing their Bitcoin.
Triangular Arbitrage
This arbitrage method involves picking three different crypto assets on one exchange and then trading the price variance between them. For example, a trader might spot an arbitrage opportunity involving XRP, Bitcoin and Ethereum. One of these coins may be underpriced on the exchange. Therefore a trader can exploit the price difference by selling their ETH for BTC, then using BTC to purchase XRP, and then complete the triangular arbitrage by buying back ETH using XRP. In case they correctly timed the market, the trader will now have more Ethereum than they had before trading.
Arbitrage Trading Risks
Slippage is a major risk that arbitrage traders must be aware of. But what is it? Slippage happens when a trader places a buy order, but that order turns out to be larger than the cheapest offer available in the order book. This leads to the order ‘slipping’, causing the trader to pay more than the expected price. If this happens, any potential profits might be wiped out.
That said, there is money to be made through arbitrage trading, but always do your own research to find out if you can tolerate the risks associated with this type of trading before opening any trades.