Cryptocurrency Arbitrage: A Guide to Trading Strategies

Cryptocurrency Arbitrage A Guide to Trading Strategies

Move over stocks and cryptocurrency arbitrage trading strategy are the planet’s newest, most exciting markets. Over the past year, we have seen cryptocurrencies top $1 trillion in market cap, with over $150 trillion 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. On the other hand, cryptocurrency can be traded in a myriad of ways on a host of different markets. This presents a great opportunity for arbitrage, where traders can profit from exploiting price differences across exchanges and assets.

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

Cryptocurrency Arbitrage Trading Strategy, Explained

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 simultaneously at different prices for the same asset.

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 gold market is said to be efficient if gold is being traded for the same price across exchanges.

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

Arbitrage traders serve an important purpose in 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 crypto arbitrage is prevalent is asymmetric information across markets for buyers and sellers. For instance, a new cryptocurrency user wants to buy Bitcoin on Coinbase.

They likely aren’t taking the time to analyze different prices across exchanges. Instead, they will use their Coinbase account to make their purchase without analyzing the price of Bitcoin across different exchanges. An arbitrage trader can exploit this information gap by exploiting market price differences.

With opportunities for arbitrage within the cryptocurrency market, traders have designed their 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. 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 trades around within minutes or seconds.

This type of trading doesn’t change the legal status of crypto arbitrage. In short, arbitrage traders often make buy and sell trades much quicker than other traders. Still, arbitrage trading is legal and runs no regulatory risk for traders.

One area arbitrage traders will want 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 every trade to pay the correct amount of taxes to the government. The IRS guidelines will subject these trades to short-term capital gains tax.

Identifying Cryptocurrency Arbitrage Opportunities

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, constantly moving up and down. This creates price disparities between cryptocurrency exchanges, and arbitrage opportunities result.

The bid price is the highest price someone is willing to spend to purchase a cryptocurrency, while the asking price is the lowest price someone is willing to sell. The difference between the bid and ask price is known as the spread, 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 on the bid and ask prices for different cryptocurrencies and 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 is from Coinbase Pro.

  • Gemini: ETH-BTC
  • Coinbase Pro: ETH-BTC

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, reaching 0.00002 BTC.

Simple vs. Triangular Cryptocurrency Arbitrage: Understanding the Difference

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 relate to simple arbitrage, which involves straight buy and sell orders across exchanges or assets.

Let’s look at another example scenario:

  • The asking 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 asking 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, producing sizable profits for the trader.

Triangular Arbitrage

A bit more complex 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, eventually producing a profit on the original asset.

In this scenario, a triangular arbitrage opportunity exists by using BTC to purchase BCH, using BCH to purchase ETH, and ETH to purchase BTC. If done instantaneously at these prices, you may be able to turn a profit.

By 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, in 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. Therefore, you must trade between assets and exchanges to take advantage of this triangular arbitrage opportunity.

Remember that triangular arbitrage opportunity are harder to identify and rarest (while also usually requiring trading algorithms). Still, when found, they can provide a pathway to profits for traders.

Cryptocurrency Arbitrage Advantages

Cryptocurrency Arbitrage Advantages

Creating Market Efficiency

Arbitrage traders 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 come closer together, creating a more efficient market. The market as a whole benefit 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 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 instantly, the profit potential 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 new cryptocurrencies and tokens come with it. Also, there are already close to 400 crypto exchanges to choose from, creating a sea of opportunities for arbitrage traders. The more cryptocurrencies created, and the more exchanges there are to trade between, the more potential for arbitrage trading.

Cryptocurrency Arbitrage Risks

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 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 in trading liquidity. Therefore, while the price of an asset across two exchanges looks ripe for an arbitrage trade, it may not be easy if the trading volumes between the two don’t align. As an arbitrage trader, you must ensure that you can place 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 the fees associated with placing an arbitrage trade. Exchange fees vary across exchanges but will always play a factor in an arbitrage trade, 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

How to Put a Cryptocurrency Arbitrage System in Place

Here is a step-by-step guide to setting up a cryptocurrency arbitrage system.

  1. Setup multiple exchange accounts – As previously discussed, cryptocurrency arbitrage often occurs in price discrepancies across different exchanges. Therefore, the more exchange accounts you have, the more opportunity there is to identify profitable arbitrage trades. Many exchange accounts allow you to seize 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 key is to have an easily repeatable trading strategy, so you can regularly trade your way to profits. 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 isn’t. That’s why arbitrage traders have a host of tools and resources to help them better identify arbitrage opportunities and execute their trading strategy.

Useful Tools for Cryptocurrency Arbitrage

Useful Tools for Cryptocurrency Arbitrage

Designing a winning arbitrage trading strategy requires using tools and resources to increase trading efficiency and timing. Rarely do arbitrage traders rely on their faculties to identify trades and execute them promptly. 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. 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 monitors multiple exchanges on a single platform. This makes it easier to identify trading opportunities without navigating between different exchanges instantly.

Exchange management features on Cove Markets let you connect with some of the industry’s most liquid exchanges like Coinbase, Kraken, Bittrex, Gemini, and Bitstamp and easily place trades across exchanges.

Other Key Arbitrage Trading Tools Include:

Other Key Arbitrage Trading Tools Include

Historical and Real-Time Exchange Data

Pricing data across exchanges tell a story of where prices are trending and what recently executed trades. This information is paramount to a successful arbitrage strategy. Good exchange data will allow you to see trades being made across exchanges, exchange volumes, and bid-ask spreads in real-time. 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 due to 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 a 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. 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 inflating their trading volume and order books to solicit more business. Trusting your trading with well-regarded exchanges like Coinbase, Gemini, and Kraken is best.

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

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 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 disappointment sometimes, as not all of your trades will work out like you want them to.

Start Slow

Starting slow is always best, even if you feel confident about your trading strategy. 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 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 various tools, like charting, order routing, and exchange data. Some platforms like Cove Markets give you all 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 much harder to swallow on a $50 trade than on a $1,000 trade. When starting, you might 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 profits through price discrepancies across crypto exchanges and 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 will fall behind other traders who are taking advantage of best-in-class software for arbitrage trading.

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