Cryptocurrency Arbitrage: A Guide to Trading Strategies

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Move over stocks, cryptocurrencies have become the newest, most exciting market on the planet. Over the past year, we have seen cryptocurrencies top $1 trillion in market cap, with over $150 trillion in daily trading volume on exchanges. And while it’s less than a decade old, the cryptocurrency industry has already beefed up its infrastructure, and allowed traders of all kinds to access the market in hopes of identifying successful trading strategies.

Traditional financial markets are highly regulated, and require regulated intermediaries to place trades and fulfill orders. Cryptocurrencies, on the other hand, can be traded in a myriad of ways, on a host of different markets. This presents a great opportunity for arbitrage, where traders can obtain profits from exploiting price differences across exchanges and assets.

Let’s take a look at how cryptocurrency arbitrage works, how to identify arbitrage opportunities, and what tools to utilize when devising a crypto arbitrage trading strategy.

Cryptocurrency Arbitrage, Explained

The idea of arbitrage has been around since markets were created. Arbitrage works because of differences in information and pricing across markets. When markets and their participants aren’t acting with all available information, trades may be executed at different prices for the same asset at the same time. In this way, cryptocurrency markets, like most markets, are not truly efficient, because an efficient market will have consistent prices across different exchanges. For instance, the market for gold is said to be efficient if gold is being traded for the same price across exchanges. 

With arbitrage, traders are taking advantage of inefficient markets by finding price discrepancies across exchanges and exploiting them to gain a profit. This commonly occurs when a trader purchases an asset at one price on one market, and sells it for a higher price on another market at, or around, the same time. Successful arbitrage traders are ones who can spot these price differences quickly and efficiently. 

Arbitrage traders actually serve an important purpose for the cryptocurrency industry. The more prices differ across exchanges, the more inefficient the market is. Arbitrage traders take advantage of these pricing differences, and in doing so, actually bring prices on different exchanges closer together, creating more parity in the marketplace and aiding in the price discovery process to make the markets more efficient. 

As a relatively new market, opportunities for trading arbitrage in cryptocurrency are more prevalent than in other markets. For one, market makers on smaller cryptocurrency exchanges often follow the lead of larger exchanges. If these small exchanges experience a lag in setting prices, arbitrage opportunities may exist.

Another reason why crypto arbitrage is prevalent is because of asymmetric information across markets for buyers and sellers. For instance, say a new cryptocurrency user wants to buy Bitcoin on Coinbase. They likely aren’t going to take the time to analyze different prices across exchanges, and instead, will use their Coinbase account to make their purchase without analyzing the price of Bitcoin across different exchanges. An arbitrage trader can take advantage of this information gap by exploiting price differences across markets.

With there being opportunities for arbitrage within the cryptocurrency market, traders have designed their own systematic arbitrage trading strategies to take advantage of these pricing differences.

Is Cryptocurrency Arbitrage Legal?

To those who don’t understand it, arbitrage trading might seem like a shady way of trading. However, this couldn’t be further from the truth. In fact, cryptocurrency arbitrage trading is the same as any other type of trading, it just happens more quickly. Arbitrage traders buy and sell cryptocurrencies based on a pre-set strategy that turns around trades within a matter of minutes or seconds. This type of trading doesn’t change the legal status of crypto arbitrage. In short, arbitrage traders often do make buy and sell trades much quicker than other traders, but arbitrage trading is completely legal by all accounts, and runs no regulatory risk for traders.

One area arbitrage traders will want to take extra caution is paying the appropriate taxes on their trades. Because arbitrage traders can make multiple trades in a single day, they will need to consider the profit and loss from each and every trade to pay the correct amount of taxes to the government. These trades will be subject to short-term capital gains tax as per the IRS guidelines. 

Identifying Cryptocurrency Arbitrage Opportunities

Arbitrage opportunities within the cryptocurrency industry can be found in many places. This is because unlike traditional financial markets, crypto exchanges don’t have the same level of transparency. Additionally, crypto prices tend to have high volatility, meaning their prices are constantly moving up and down. This creates price disparities between cryptocurrency exchanges, and arbitrage opportunities as a result.

The bid price is the highest price someone is willing to spend to purchase a cryptocurrency, while the ask price is the lowest price at which someone is willing to sell. The difference between the bid and ask price is known as the spread, and this is where traders can identify arbitrage opportunities. Simultaneously viewing order book prices on different exchanges may expose price differences between bid and ask prices across those exchanges. 

Looking at a typical order book will give you information as to not only the bid and ask prices for different cryptocurrencies, but also the volume of potential trades. This is how you can easily identify the size of a crypto arbitrage opportunity as you can only buy as much as another trader is willing to sell, and visa-versa.

Let’s look at an example. The following screenshots for the Ethereum-Bitcoin market were taken at the same time. The first is from Gemini and the second from Coinbase Pro

Gemini: ETH-BTC

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Coinbase Pro: ETH-BTC

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Notice the current market price for both exchanges. The price for 1 ETH on Gemini is 0.03769 BTC, while the price on Coinbase Pro is 0.03767 BTC. Therefore, an arbitrage opportunity exists by  purchasing BTC on Coinbase Pro and immediately selling it on Gemini. Executing this trade correctly would net a profit on the spread, which comes out to 0.00002 BTC.

Simple vs. Triangular Cryptocurrency Arbitrage: Understanding the Difference

While there are a variety of arbitrage trading strategies throughout financial markets, the two most common in the cryptocurrency industry are simple and triangular arbitrage.

Simple Arbitrage

Simple arbitrage is exactly how it sounds, simple. Most of what has already been discussed relates to simple arbitrage, which involves a straight buy and sell order across exchanges or across assets.

Let’s look at another example scenario:

  • The ask price for Bitcoin on exchange A is $34,875
  • The bid price for Bitcoin on exchange B is $35,000

If you purchase Bitcoin at the ask price on exchange A, you can immediately sell it on exchange B for a $125 profit. Note that you might not see such a big difference between the bid and ask price across markets. Instead, simple arbitrage opportunities often exist when prices differ only marginally, and when a large enough volume is traded, produce sizable profits for the trader.

Triangular Arbitrage

A bit more complex of a trading method, triangular arbitrage involves identifying price discrepancies between three different assets which can be utilized to turn a profit. This requires making three trades between assets, which eventually produces a profit in the original asset held.

 

Let’s look at an example. Imagine you are on an exchange and notice the following exchange rates:

In this scenario, a triangular arbitrage opportunity exists by using BTC to purchase BCH, using BCH to purchase ETH, and lastly using ETH to purchase BTC. If done instantaneously at these prices, you may be able to turn a profit. From placing these trades simultaneously or in quick succession, you may be able to turn 1 BTC into 1.0125 BTC (excluding trading fees) through the triangular arbitrage process. The trades look like this:

  • 1 BTC → 45 BCH
  • 45 BCH → 67.5 ETH
  • 67.5 ETH → 1.0125 ETH

It’s important to note that this triangular arbitrage example may exist on one exchange, but is more likely to be prevalent across multiple exchanges where price discrepancies are identified. For instance, going back to our previous example, the BCH/BTC rate could come from Exchange A, the BCH/ETH rate from Exchange B, and the BTC/ETH rate from Exchange A as well. Therefore, you would have to trade not only between assets, but between exchanges as well in order to take advantage of this triangular arbitrage opportunity.

 

Keep in mind, triangular arbitrage opportunities are harder to identify and are rarest (while also usually requiring trading algorithms), but when found they can provide a pathway to profits for traders. 

Cryptocurrency Arbitrage Advantages

Creating Market Efficiency

Arbitrage traders actually serve a valuable purpose to the entire cryptocurrency market. By exploiting price differences between exchanges, arbitrage traders bring prices  closer together across markets, and thus, closer to equilibrium. When an arbitrage trader buys and sells a cryptocurrency across two exchanges, those prices then come closer together, creating a more efficient market. The market as a whole benefits from price consistency across exchanges, and with the help of arbitrage traders, such consistency can be better achieved.

Profiting From a Time-Tested Strategy

As previously mentioned, arbitrage trading has existed in every market imaginable, making it a time-tested strategy for traders. Cryptocurrencies simply represent another arbitrage opportunity for traders, who can employ similar arbitrage trading strategies from other markets to turn a profit.

Fast Profits

Because arbitrage trades happen in an instant, the potential for profit exists in the short-term, and not long-term holding. Successful traders can realize a profit on multiple arbitrage trades in a single day if the opportunities present themselves.

A Growing Number of Tradable Assets and Exchanges

The cryptocurrency industry is growing by the day, and with it comes new cryptocurrencies and tokens. Not only that, there are already close to 400 crypto exchanges out there to choose from, creating a sea of opportunities for arbitrage traders. The more cryptocurrencies that are created, and the more exchanges there are to trade between, the more potential will exist for arbitrage trading.

Cryptocurrency Arbitrage Risks

Just like any trading strategy, arbitrage has its own set of risks that can turn a potentially good trade into a loss extremely quickly. These risks include:

Price Slippage

When placing a market order, you may expect to execute a trade at a certain price given its price at that moment on the exchange. However, in the time it takes to execute the trade (which only has to be a fraction of a second), the price may  change, altering the profitability of your trade. This is known as price slippage.

Unexpected Price Movement

Arbitrage pricing opportunities can disappear in an instant. If the arbitrage trade isn’t executed instantly, prices could unexpectedly change, and change the profit potential of the trade as well. Timing a trade incorrectly could cause a trading loss, instead of a gain.

Lack of Liquidity 

Exchanges differ on trading liquidity. Therefore, while the price of an asset across two exchanges looks ripe for an arbitrage trade, it may not be so easy if the trading volumes between the two don’t align. As an arbitrage trader, you have to ensure that you are able to place both buy and sell orders across exchanges at the same trading volume without any problems. This tends to be more of an issue on smaller exchanges with less trading liquidity.

Trading Fees

You can’t forget to consider fees associated with placing an arbitrage trade. Exchange fees vary across exchanges, but will always play a factor in an arbitrage trade, thereby reducing the overall profit potential in any given arbitrage situation. Don’t forget about all applicable fees you may encounter, like fees for crypto-to-fiat conversion, deposits/withdrawals, and blockchain-related fees.

How to Put a Cryptocurrency Arbitrage System in Place

Here is a step-by-step guide for how you can set up a cryptocurrency arbitrage system.

  1. Setup multiple exchange accounts - As previously discussed, cryptocurrency arbitrage exists most often in price discrepancies across different exchanges. Therefore, the more exchange accounts you have, the more opportunity there is to identify profitable arbitrage trades. Having a multitude of exchange accounts on hand allows you to take advantage of the most arbitrage opportunities possible.
  2. Identify and quantify arbitrage opportunities - Use real-time market data and other tools to identify an arbitrage opportunity and the potential profit from the trade. This may require using pricing data across exchanges.
  3. Execute trades - After a trade has been identified, execute the trade and calculate your profit/loss exposure.
  4. Repeat and grow profits - Anyone can get lucky and profit from a single arbitrage trade. The real key is to have a trading strategy that is easily repeatable, so you can trade your way to profits on a regular basis. Analyze your previous trades and look for patterns and trends which lend themselves to a successful long-term trading strategy.

This process might sound simple, but it really isn’t. That’s why there are a host of tools and resources for arbitrage traders to help them not only better identify arbitrage opportunities, but execute on their trading strategy as well.

Useful Tools for Cryptocurrency Arbitrage

Designing a winning arbitrage trading strategy requires the use of tools and resources to increase trading efficiency and timing. Rarely do arbitrage traders rely on their own faculties to identify trades and execute them in a timely manner. Instead, they rely on systems that can help to identify and place trades across multiple exchanges to increase trading efficiency and capture even more arbitrage opportunities. In fact, many of the existing tools for arbitrage traders will also help to mitigate the risks of this type of trading, such as price slippage and movement.

 

Maybe the most important tool for arbitrage trading is multiple exchange management. Monitoring prices across exchanges is a tedious and time-consuming process. This is why you need a tool that allows for monitoring of multiple exchanges in a single platform. This makes it easier to identify trading opportunities in an instant, without navigating between different exchanges. Exchange management features on platforms like Cove Markets let you connect with some of the industry’s most liquid exchanges like Coinbase, Kraken, Bittrex, Gemini, and Bitstamp, and place trades across exchanges with ease.

 

Other key arbitrage trading tools include: 

Historical and Real-Time Exchange Data 

Pricing data across exchanges can tell a story of where prices are trending and what trades have been recently executed. This information is paramount to a successful arbitrage strategy. Good exchange data will allow you to see in real-time trades being made across exchanges, exchange volumes, and bid-ask spreads. This will help to identify arbitrage trading opportunities more quickly than the competition.

 

Best Price Order Routing 

This function routes your order to the market maker offering the best possible price for a given trade. A good order routing software will place trades quickly, and save you money as a result of a more efficient trade. Arbitrage opportunities appear and disappear in a matter of seconds or milliseconds, so ensuring timely trades at the best price can be make-or-break for any arbitrage trading strategy.

Advanced Charting 

Utilizing price charts can help you spot an arbitrage opportunity before it happens. These tools identify pricing patterns and use technical indicators to predict price movements in any given market. Using technical analysis like trendlines, moving averages, and candles can give you the edge you need to spot a potential arbitrage opportunity from afar. The more charting indicators at your disposal, the more information you have to generate a winning arbitrage strategy.

Other Infrastructure

On top of these arbitrage-specific tools, you still want to ensure you have a solid foundation of cryptocurrency infrastructure. This means keeping your cryptocurrency safe in a secure wallet and using only reputable exchanges to place your trades. Unfortunately, some exchanges are notorious for having security vulnerabilities, and/or inflating their trading volume and order books to solicit more business. It’s best to trust your trading with well-regarded exchanges like Coinbase, Gemini, and Kraken.

 

Tips If You’re Trading Cryptocurrency Arbitrage for the First Time

Arbitrage trading isn’t for everyone, but if you want to get started, keep in mind these tips for your first arbitrage trade.

Not All Trades are Winners

You might think that you’ve found the perfect arbitrage trade, only to execute the trade and make little to no profit. That’s ok. Arbitrage trading happens so quickly that a seemingly good trade might not work out in your favor. Get used to being disappointed at times as not all of your trades will work out like you want them to.

Start Slow

Even if you feel confident about your trading strategy, it’s always best to start slow. Reduce your initial arbitrage trading volume at first so you can ensure you fully understand the trading process, which tools work best for you, and what could go wrong. Once you work the kinks out of your arbitrage strategy, you can then up the ante and start working on larger trading volumes.

 

Try Out New Tools

Crypto arbitrage success can often be determined based on the quality of tools at your disposal. So go out there and test out a range of tools, like charting, order routing, and exchange data. Some platforms like Cove Markets give you all of these resources in one place, making it easy to take advantage of these technological tools.

Remember Those Fees!

This is especially important for beginners who might only be risking a small amount of capital on their trades. A $1 trading fee is proportionally a lot harder to swallow on a $50 trade than it is on a $1,000 trade. When you’re first starting out you might just have to concede that trading fees will substantially eat into your profits.

Conclusion

Arbitrage trading has been available in every market since the beginning of time, and cryptocurrencies are no different. A successful arbitrage trading strategy can net you profits by way of price discrepancies across crypto exchanges and/or assets. 

 

These days, the only real way to be a successful arbitrage trader is to utilize software tools to help execute your trading strategy in real-time. Cove Markets is the perfect example of an arbitrage trading software that puts you in the driver’s seat. With Cove Markets you gain access to real-time and historical data across multiple crypto exchanges, best price order routing technology, advanced charting tools, and even high-level data encryption for security.

 

If you aren’t using tools like Cove Markets, you are going to fall behind other traders who are taking advantage of best-in-class software for arbitrage trading.

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Scott Knudsen is CEO of Cove Markets. He spent 14 years at IMC Trading, working in Chicago, Amsterdam, and Hong Kong. Follow him on Twitter here.

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