How to gain from crypto arbitrage
13:08, 16 June 2021
Even though cryptocurrencies have evolved to become a multi-trillion market, low liquidity is something this growing asset class must overcome to reduce high levels of volatility.
Illiquidity creates an opportunity for sophisticated traders to come up with a crypto arbitrage strategy that allows them to profit from asymmetric prices quoted by different exchanges at the same time for the same token.
In the following article, we look at what cryptocurrency arbitrage is and how you can use it to profit from inefficiencies in the market.
What is crypto arbitrage?
Cryptocurrency arbitrage aims to generate a profit from differences in a token’s price across multiple exchanges. There are hundreds of centralised and decentralised exchanges through which market participants can buy and sell cryptocurrencies.
Most big exchanges use proprietary price discovery systems, creating an opportunity to profit from any small differences between exchanges for a given crypto pair.
A traditional crypto arbitrage strategy is to buy a token at a lower price on Exchange A and then sell it for a higher price on Exchange B. Other strategies can generate the same result, such as by placing a chain of trades or taking advantage of decentralised exchanges, which often produce even less symmetrical pricing compared to large centralised ones.
The following is a quick summary of the most common types of crypto arbitrage:
Manual arbitrage: a trader tracks the price of one or more tokens across multiple centralised or decentralised exchanges. They quickly place trades when there’s a positive difference between the price of a given token in Exchange A compared to Exchange B. A long arbitrage strategy would start by buying the token at a lower price in Exchange A, transferring it and selling on Exchange B at a higher price. A short arbitrage strategy would involve selling a token on Exchange A to then buying it at a lower price on Exchange B.
Cross-currency (triangular) arbitrage: this consists of buying multiple cryptocurrency pairs to ultimately obtain a higher number of the same token. An example involves converting BCH to ETH, then changing the newly acquired ETH to a higher amount of BTC.
Automated arbitrage: by using algorithms and machine learning, traders expert in coding can create automated systems that identify crypto arbitrage opportunities and execute trades without manual input. Through these systems, a trader could perform hundreds of trades within a short period to take advantage of asymmetric quotations.
How to arbitrage crypto?
The first step to arbitraging cryptocurrencies is to pick your strategy. If you’re going to arbitrage manually, you’ll spend hours looking at your computer screen. You’ll need to sign up to multiple exchanges – centralised and decentralised. Your wallet(s) must be connected to all of them so you can perform trades quickly before the market corrects the asymmetry.
Once you’ve completed that first step, you should select which tokens to track and spot arbitrage opportunities. Although illiquid tokens might appear an obvious choice due to the high levels of asymmetry in their quotations across exchanges, the same factor that makes them attractive could also be an obstacle when conducting an arbitrage strategy.
The reason is that your trades may not be executed because of a lack of market depth – meaning that there might not be sell orders to match your buy order and vice versa.
Therefore, arbitraging with the most liquid pairs and tokens is perhaps the best choice. The most liquid tokens at the moment – excluding stablecoins – are bitcoin (BTC), ethereum (ETH), XRP (XRP), ethereum classic (ETC) and litecoin (LTC).
Meanwhile, if you’re going to develop an algorithm to identify these temporary asymmetries, you’ll probably have to take some lessons on how to code your trading strategy, unless you are a developer or have some advanced knowledge in programming languages such as Python.
The algorithm will constantly monitor the intraday fluctuations in the price of one or more tokens to identify temporary and meaningful asymmetries that provide an opportunity for the arbitrageur.
When that happens, the algorithm can either trigger an alarm that informs the trader about an asymmetry, or the algorithm could be programmed to execute the trade automatically. It’s important to note that the speed of execution and other relevant factors, such as trading fees and market depth, are crucial to perform a profitable arbitrage.
Examples of crypto arbitrage
How to find a crypto arbitrage opportunity? Well, either you remain glued to your screen, or you learn the coding needed to work with the APIs of multiple exchanges to set alerts or to program an algorithm to automatically execute trades once price discrepancies are identified.
Here’s an example of how a crypto arbitrage strategy would work in practice:
In this hypothetical trade, the operation starts by converting 1.000 BTC into 138.23611 LTC. Those 138.23611 LTC are then turned into 54.66665 ETH at a rate of 2.52871 LTC/ETH, which are then exchanged into BTC at 0.01894 BTC/ETH. That results in a total of 1.03539 BTC, giving a profit of 0.03539 BTC.
This is an example of a triangular arbitrage, one of the most complex crypto arbitrage trading strategies. The traditional arbitrage strategy, which consists of identifying asymmetries in the price of a certain token across two exchanges, is much simpler.
Frequently Asked Questions (FAQ)
Is crypto arbitrage legal?
Yes. This strategy is followed by arbitrage traders specialising in multiple different asset classes, including stocks, bonds and commodities. In fact, arbitrageurs make markets more efficient as they reduce the price asymmetries they seek to exploit.
Is crypto arbitrage profitable?
The profitability of a crypto arbitrage strategy depends on the following variables:
Execution speed of the trades involved
What is a crypto arbitrage bot?
A bot is a system programmed to execute trades automatically once certain conditions have been met. Arbitrage traders use bots to either identify arbitrage opportunities by setting alarms that inform the trader about a certain asymmetry or by placing trades required to profit.
A bot is built by designing algorithms that use APIs - interfaces through which users can download and analyse information from the database of the exchanges they’re tracking. Their complexity and sophistication vary depending on the trader’s strategy.