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Lesson 16: Cryptocurrency Arbitrage

Lesson 16: Cryptocurrency Arbitrage

This guide will focus on a few of the most straightforward cryptocurrency arbitrage options available.

Tens of billions worth of cryptocurrency is exchanged every day in millions of trades. Unlike the traditional stock and currency exchanges, dozens of crypto exchanges offer different prices for the same assets.

For savvy traders—and ones who aren’t averse to a little risk—that opens an opportunity to get the edge over their compatriots: play these exchanges against each other. Welcome to the world of cryptocurrency arbitrage.

What is cryptocurrency arbitrage?

Arbitrage is the process of taking advantage of price inefficiencies in financial markets. While cryptocurrency isn’t legal tender in most countries, it’s a tradable asset. Its volatile price can often cause price discrepancies. It is possible to buy and sell the same asset on different exchanges (or even on the same exchange) in a way that can result in a profit for the trader.

Let’s say that Bitcoin trades at around $9,900 on Exchange A, while on Exchange B, the BTC trading price is at around $9,800. The key to cryptocurrency arbitrage is to exploit this difference in price on the two exchanges. A trader could buy Bitcoin on Exchange B, then transfer the BTC to Exchange A to sell it for a $100 profit. However, traders should also consider network fees and other fees charged by the exchanges.

Another major aspect of these profit opportunities is timing. Usually, the price differences don’t last for long, and traders must act fast. The hassle may be well rewarded, as the arbitrageur can gain massive profits. In the crypto markets, new cryptocurrency listings can present massive price discrepancies during the first few hours. For instance, in October 2020, Filecoin was listed for $30 on some exchanges, while others had it trading for around $200.

How do crypto prices work?

How do cryptocurrencies gain value? Some cryptocurrency critics argue that cryptocurrency isn't backed by any tangible assets and that it relies purely on speculation. However, that’s not entirely true, as people are willing to pay for cryptocurrency. The price of crypto follows the simple rule of supply and demand. Indeed, most cryptos’ prices are the product of speculations because the market is still in its infancy.

When trading on centralized crypto exchanges, the prices are determined by order books. These order books include buy and sell orders at various prices. A trader might place a "buy" order for one Bitcoin to be purchased at $10,000. This order would be added to the order book. A "sell" order could be added to the book if another trader wishes to sell Bitcoins for $10,000. Once the buy order has been fulfilled, it is removed from the order book, as the trade meets all conditions and can occur.

The most centralized crypto exchanges set their crypto prices using the order book system. There are only a few exceptions of crypto exchanges that base their prices upon other cryptocurrency exchanges.

To better understand how order book exchanges work, let’s take an example.

Crypto arbitrage - order book
In this illustration, the Bid orders are placed on the left, while the Ask orders are on the right. Let’s say you want to execute your trade immediately. In this case, you would be the taker. To make sure your trade is executed instantly, you can either set a limit order to match the other side of the bid-ask spread or simple execute a market order, which will take whatever price the asset is currently trading at.

Crypto arbitrage step by step

Step 1: Collect order book data on each exchange for assets that you would like to evaluate for arbitrage.

Crypto arbitrage - step 1

Step 2: Identify the arbitrage opportunity by looking at the overlap between the bid and ask prices on each exchange for the individual asset you are evaluating.

Crypto arbitrage - step 2

Step 3: Sell the asset on the exchange where the price is higher and buy on the exchange where the price of the asset is lower.

Crypto arbitrage - step 3

Step 4: Continue selling the asset on the exchange where the price is higher and buying on the exchange where the price is lower. This will consume the order book.

Crypto arbitrage - step 4
Step 5: Once the entire opportunity has been consumed, stop buying and selling the asset.

Crypto arbitrage - step 5

How is an arbitrage opportunity calculated?

To calculate arbitrage opportunities, the trader must find the highest and the lowest trading prices. To make arbitrage profitable, the Ask price for a cryptocurrency on an exchange must be higher than the Bid price on another exchange.

However, even if you spot an arbitrage opportunity, itțs advisable that you calculate the potential profit, before jumping into the trade. When calculating the arbitrage value, one thing to keep in mind is that the execution of arbitrage will consume the order book. Let's take, for example, "Step 2" as shown in the illustration above. We have highlighted in this step the amount of overlap in the order book.

This means that the Ask price for the highlighted area on an exchange is either higher or lower than the Bid price.

Once we start executing on the arbitrage chance, we see in steps 4 and 5, that the arbitrage possibility shrinks after each price is taken. We cannot capitalize on the entire value highlighted in yellow (the area of depth) in step two, but only on a small fraction.

This trading consequence must be taken into consideration when calculating the potential size of an opportunity. This can be done by simulating the executions of actual buys or sells that we would make on the exchange during arbitrage.

Different types of cryptocurrency arbitrage

#1 Between exchanges

One way to arbitrage cryptocurrency is to trade the same crypto on two different exchanges. In this case, you would purchase a cryptocurrency on one exchange and then transfer it to another exchange that sells the same cryptocurrency at a higher rate. However, this method has its limitations. The first obstacle would be the time needed to transfer the assets from one exchange to the other. Note that cryptocurrency spreads are only temporary, and transferring between exchanges may take several minutes, or in some cases, even longer. Another issue is transfer fees. To profit from crypto arbitrage between two exchanges, the trade should cover the withdrawal, deposit, or network fees.

The price of Bitcoin can differ between exchanges. Image source: Coinranking.com

However, there is a way to void all the transfer and gas fees. Arbitrageurs can avoid transaction fees by holding currency on two exchanges. This allows traders to simultaneously buy and sell cryptocurrency.

Let's look at how it might work: A trader could have one account on Binance that holds $10,000 in a stablecoin such as USDT or DAI (a cryptocurrency pegged to the US dollar) and one account on Coinbase that holds one Bitcoin. The trader would purchase one Bitcoin on Binance, using the stablecoin, and then sell the one Bitcoin on Coinbase. If the price of one Bitcoin is $10,200 on Coinbase, the trader would still have one Bitcoin, while also making a profit of $200 because of the spread between the exchanges.

#2 Triangular arbitrage

Triangular arbitrage is a popular arbitrage strategy in forex trading, and it requires the trader to swap between three different cryptos on one exchange. In this case, transfer fees shouldn’t be an issue, as all trades take place on the same exchange.

Please look at the following illustration to understand how you can profit from a triangular arbitrage.

In this example, we have three different cryptos on one crypto exchange. We’ve chosen LTC/BTC, LTC/ETH, and ETH/BTC pairs in this example. To profit from this arbitrage opportunity, you would need to follow these four steps:

  1. Start trading with the first asset. The first asset should be the one to which you will return after the arbitrage process is done.
  2. Then trade the first asset for the second asset. This is only a hop to get to the third asset in this triangular arbitrage.
  3. Trade to a third currency. Due to the price discrepancies between the three assets, you will be now able to make a profit.
  4. Convert the third crypto for the original asset and enjoy your profit.

In this example, we begin with 1 BTC. To calculate the value of the arbitrage opportunity, you will need to calculate the bid and ask price for each pair in this triangle. Note that the bottom trade uses the asking price, and we divided ETH by LTC to calculate the ratio. After each value is calculated, go around the triangle and multiply or divide with the value for each operation, as illustrated above. The calculation should look like this:

1.00000 x 138.23611 ÷ 2.52871 x 0.01894 = 1.03539 BTC

After the final trade, when you trade back to BTC, you can compare the end value with the value that you started with to determine the size of the arbitrage opportunity. In this example, the end value is 1.03539 BTC. When we compare this to the starting value, we can see that the profit is 0.03539 BTC. By executing on this triangular arbitrage opportunity, we have a larger BTC holding.

Note that you can also execute triangular arbitrage across different exchanges.

Arbitrage Trading Risks

Traders should know that arbitrage trading is not risk-free. One of the risks associated with arbitrage is slippage. Slippage is when a trader places an order to buy cryptocurrency, but the order is larger than the lowest offer in the order book. This causes the order to slip and costs more than they anticipated. Slippage can be a problem for traders because the margins are so low that it could wipe out potential profits.

Arbitrage is also subject to price movement. Spreads can disappear in a matter of seconds so traders must be quick to capitalize on them. Arbitrage trading has become more competitive because some traders use automated bots to do the job.

Transfer fees are another risk associated with arbitrage opportunities. Spreads for major cryptocurrencies (see cryptocurrency list) are not extremely high. With tight margins, a transaction fee or transfer fee could wipe out any potential profits. This tight margin means that traders who want to make substantial gains in online trading must execute a lot of trades.

Putting it all together

Now that you know how to find and calculate cryptocurrency arbitrage opportunities, you can use all this knowledge to devise a complete arbitrage trading strategy.

First - Fund Exchange Accounts

You can place funds on two exchanges that you will be closely monitoring for arbitrage opportunities. These funds can be used to execute simple arbitrage, where the same asset can be bought or sold instantly if an opportunity arises. You should have funds on multiple exchanges as the transfer of funds between them can be time-consuming and costly. Having this setup will make it easier to capitalize on the arbitrage opportunity the moment it arises.

Second - Identify Opportunities

Look for differences in pricing between exchanges to identify opportunities. To see where they overlap, compare the highest bid prices with the lowest ask prices. Any overlap is an opportunity for arbitrage.

Third - Quantify Opportunities

Simulating the sale and purchase of an asset will help you calculate the potential value. Note that the buy and sell process will consume your order book, so make sure you are aware of the changes.

Fourth - Execute the Strategy

You can immediately place orders on the exchange to execute the strategy. For as long as there is an arbitrage opportunity, you can continue placing orders on that exchange.

Fifth - Do It Again

Stop trading when the arbitrage opportunity has disappeared. It is time to start looking for new opportunities and repeat the process.

Bottom line

  • Cryptocurrency arbitrage is a trading process that takes advantage of the price differences on the same or on different exchanges.
  • Arbitrageurs can profit from opportunities that arise by trading on multiple exchanges simultaneously or by trading for a triangular arbitrage on the same exchange.
  • The risks associated with arbitrage trading include slippage, price movement, and transfer fees.

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