Arbitrage for Cryptocurrency Explained for Beginners

Imagine you purchase an asset and sell it for a guaranteed profit, basically removing all the market risks. This concept is called Arbitrage, and it is becoming increasingly more relevant in today's hyper-volatile digital asset space, which operates continuously, around the clock, seven days a week. Although the term "risk-free" is a big claim and will require much evaluation, traders are motivated to take advantage of instantaneous price differences across exchanges as a means for profit creation on a global level.

This guide seeks to provide an overview of Arbitrage for Cryptocurrency through simple-to-follow action steps. In addition, it will discuss why price discrepancies occur across Exchanges and outline the key strategies and considerable risks for beginners to understand prior to getting involved in Arbitrage.

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What is Crypto Arbitrage?

Arbitrage is the "holy grail" of every cryptocurrency investor looking for an effortless way to earn profits. The goal of arbitrage is to make money with little to no risk by taking simultaneous advantage of the price disparity between similar assets.

In its simplest definition, arbitrage is buying and selling an asset at the same time to capitalize on a very small price difference between them. For example, if you purchased a pound of coffee beans at $5.00 from one vendor and then immediately sold them for $5.10 at another vendor, you have successfully executed an arbitrage.

Utilizing Arbitrage strategies for Cryptocurrency would involve purchasing a certain coin (i.e., Bitcoin, Ethereum, etc.) at a lower price on one exchange and immediately selling it on another exchange at a higher price.

The reason price disparity occurs within the Cryptocurrency Market is primarily due to several factors that inherently create inefficiencies across Cryptocurrency Exchanges as a result of the Cryptocurrency space being highly fragmented compared to traditional stock markets.

The following are reasons for these price discrepancies:

• Differences in Liquidity: There may be a greater volume of buyers/sellers at an Exchange, thus the Exchange can cater to greater volumes of transactions without causing noticeable change in its prices.

• Disparity of Geographical Demand: Different exchanges may experience vastly different Demands for certain coins based upon their geographic location and User Base.

• Transfer Speed: A Transfer to an Exchange can take time due to a network of Blockchain confirmations. 

  
  

Therefore, traders must understand Arbitrage within the Cryptocurrency Market and how to apply it.

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Types of Crypto Arbitrage Strategies

Arbitrage can take on several different forms, starting with the simplest and moving to more complicated types.

1. Spatial Arbitrage (Cross-Exchange Arbitrage)

This is the most well-known type of Cryptocurrency Arbitrage. It is also the easiest for beginners to begin with.

• Process: You take advantage of the difference in price between two independent Exchanges (ex, Binance and Kraken). You buy an asset from Exchange A (which has a lower price), send it to Exchange B via blockchain, and then you sell it on Exchange B (which has a higher price).

• The biggest obstacle to this strategy is the need to determine both the timeframe and cost incurred while moving the asset between Exchanges. The time taken to perform a transaction on a blockchain is the largest risk involved.

  
  

To understand the tools that help identify these discrepancies, check out our guide on Top Technical Analysis Tools.

2. Triangular Arbitrage

This strategy is a far more specialized, sophisticated approach tailored specifically for the area of cryptocurrency trading.

• Mechanism: Rather than trading between the two exchanges, you capitalise upon the different price points of three related currency pairs traded on the same exchange at that moment. In this case, you don’t have to wait for your coin to be sent from one exchange to another.

  
  

The Process:

• You purchase your first currency (e.g., USDT) and create an Amount Of BTC.

• You can then take the BTC amount and convert it into the Amount Of ETH.

• You will then convert this Amount Of ETH back into your starting currency (USDT).

  
  

• Goal: If the total value of USD contained in your final Amount of USDT exceeds the USD contained in your initial Amount of USDT, then your attempt at triangular arbitrage has been successful.

• The Advantage: The execution of each part of the triangular arbitrage strategy takes place practically instantaneously; this makes it particularly suited for implementation using automated trading systems.

A Beginner's Step-by-Step Guide

Are you ready to take it on? Here’s your roadmap for how to safely approach the easiest method of arbitrage trading—cross-exchange arbitrage.

Step 1: Preparation and Platform Setup

• Create Accounts: Go to at least two different, high-volume exchanges and complete your account setup and KYC verification process.

• Funding Your Accounts: You’ll need to deposit fiat money or stablecoins (examples: USDT) into both exchange accounts to enable you to move quickly.

• It is important to know your trading fees (buy/sell) and withdrawal fees for the cryptocurrency you are transacting with, as well as the estimated network/gas fee for transferring it to another cryptocurrency exchange.

Step 2: Identify a Viable Opportunity

• Look at price aggregators that provide current prices across multiple exchanges or develop an API to assist you in identifying a possible arbitrage opportunity.

• Arbitrage Test: For your trade to be profitable, you will need to have a price difference of a significant amount greater than the total transaction costs (trading fee + withdrawal fee + network/gas fee). Many times, an arbitrage spread of one percent will be necessary to offset your fees.

Step 3: Execution

Consider an arbitrage opportunity you have discovered:

Exchange A = You can buy Bitcoin (BTC) for $60,000 

Exchange B = You can sell BTC for $60,100

• Buy BTC at Exchange A.

• Withdraw BTC from Exchange A to deposit it into Exchange B's wallet address.

• The BTC is now in "transit." This is the stage where you have the highest risk of not being able to convert your asset before it reaches Exchange B.

• When the BTC arrives at Exchange B's wallet, immediately sell it at whatever price it is at. If the price of the BTC is above $60,000 (and you covered the cost of the transaction fees), you made a profit.

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Why Arbitrage Isn't "Risk-Free"?

The most common misconception regarding the arbitrage trading of cryptocurrencies is that it is guaranteed to produce profit due to the mathematical fundamental basis behind the concept of arbitrage. However, several factors can prevent you from realizing an arbitrage benefit through the actual execution of the trade.

1. Speed and Market Volatility

• Cryptocurrency arbitrage is mostly exploited very quickly by automated systems, known as "arbitragebots". They are much faster than human traders at scanning the exchanges for price discrepancies and taking advantage of them. By the time a trader sees a spread, buys an asset, and transfers it to the desired exchange, the price could be gone or already have normalized.

• High-frequency trading (HFT) firms have dominated this industry because high-frequency traders can execute trades in a fraction of a second (i.e., they operate at very low latency).

2. Transaction Costs Erase Profit

One major threat to new traders is transaction fees erasing profits. For example, a trader can find a profit opportunity with a 0.2% price difference between two exchanges, but that profit disappears when the trader pays a fee (often 0.3%) to withdraw their profit.

3. The Transfer Delay Risk (The "In-Transit" Problem)

• Always calculate the Net Profit considering all transaction fees when dealing with Arbitrage opportunities across different exchanges. Also, network fees may be much greater during times of heavy network congestion.

• The Risk of Delay During Transfers ("In-Transit Risk"): This is the biggest risk with spatial arbitrage trading. You’ve bought your asset on Exchange A, and your asset is sitting on the blockchain waiting for confirmation on Exchange B. During this period (which could be seconds or minutes), a large drop in the total cryptocurrency market could create a situation where you’re left with no profits and forced to sell your asset at a loss or no profit.

  
  

To learn more about the effects of market volatility, visit our guide to Managing Risk When Trading Stocks.

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Conclusion

Cryptocurrency Arbitrage is an attractive way of taking advantage of the differences in price between different exchanges for the same digital asset.

Although most of the large arbitrage opportunities have now been taken over by traders' bots and are therefore very challenging for a new trader to identify, the new trader can still find many small profits for themselves, particularly when trading smaller volumes or when there is a lot of price volatility between two exchanges. A smart strategy would be to only focus on the smaller profit opportunities as opposed to trying for the big ones.