Disclaimer: This is for informational purposes and is not meant to serve as financial or investing advice.
What Is Arbitrage Trading?
Arbitrage trading is the practice of capitalizing on price discrepancies between different marketplaces. There are many types of arbitrage trading, but most rely on making a small profit over and over from one strategy on multiple assets.
Arbitrage can be an ethically murky situation. Sometimes pricing discrepancies happen because of a mistake in blockchain code, and taking advantage of these trades could bankrupt innocent blockchain activity.
But most of the time, arbitrage traders provide a service to the market by keeping prices uniform. This is part of a healthy crypto market!
Because of a lack of centralized authority to decide prices, you may need an army of arbitrage bots and traders to regulate prices.
How Does Arbitrage Work in Crypto Trading?
Like in other markets, crypto arbitrage is when you capitalize on price differences of one or more assets between different marketplaces.
So in crypto, this can mean trading digital assets on one exchange, sending them to a self-custody wallet, and selling them for a better price on a decentralized trading platform.
It can mean buying a token on one blockchain and “bridging” it to another blockchain where you can sell it for higher prices.
You can bridge some NFTs between chains and take advantage of marketplace price differences.
Why Are Crypto Prices Different Across Exchanges?
For various reasons, prices can differ across exchanges, primarily due to regular market activity.
Exchanges with lower liquidity tend to be more volatile. Look for less popular exchanges or exchanges that just started supporting a token for low liquidity price differences. But be sure to factor in slippage when taking advantage of this trade.
When volume increases on one exchange but not another, that causes price differences. Usually, exchanges with greater liquidity attract more traders and more volume.
What Are the Main Types of Crypto Arbitrage?
1. Cross-Exchange
Cross-Exchange arbitrage is a trading strategy where you capitalize on price discrepancies between exchanges. For example, Token XYZ trades for $100 on one exchange and $105 on another.
To execute an arbitrage strategy, you would buy Token XYZ for a lower price, send it to the exchange with a higher price and sell it there.
2. Spatial
Why do price discrepancies persist? Sometimes there are barriers to using exchanges, like only being able to register in certain countries or regions. Taking advantage of regional products and services to exploit price differences is called spatial arbitrage.
Some tokens can only be bought on geographically restricted exchanges. And because of those restrictions, investors outside of those regions may pay a premium for exposure to the cryptocurrencies.
Most exchanges require KYC (Know Your Customer) to prove you are a citizen of a covered country. A popular (illegal) arbitrage practice is buying the login for a KYC’ed account to access those trading pairs.
3. Triangular
Triangular arbitrage is when you take advantage of favorable exchange rates between three currencies.
An example is trading ETH for USD, then USD for Bitcoin (BTC), then Bitcoin back to ETH. If you end up with more ETH at the end of these trades, you’ve successfully executed a triangular arbitrage.
Triangular arbitrage opportunities are rare. And most chances in the open market are quickly resolved by bots. The tax implications of executing triangular arbitrage aren’t favorable either. But many crypto arbitrage traders are day traders or trading desks which gives them a leg up on taxes compared to beginners.
However, with the cross-chain, cross-exchange nature of cryptocurrency trading, you may still be able to get creative and find triangular arbitrage.
4. Decentralized
Decentralized arbitrage can be differences in prices on decentralized exchanges, NFT marketplaces, yield farms, or between blockchains.
In the blockchain world, there are many tokens and platforms with prices for them. Crafty traders combine smart contract interactions to create complex arbitrage opportunities.
One of the downsides of trading on a decentralized public ledger is that anyone can spot your arbitrage strategy and copy it. Crypto trading bots are even programmed to scour the blockchain for arbitrage opportunities.
Crypto arbitrage bots are popular in the blockchain space. Smart contract protocols like Ethereum allow bots to detect and capitalize on arbitrage trades instantly.
Potential profits of on-chain arbitrage are often significantly reduced by bots. They are constantly monitoring for price differences in on-chain assets. As soon as the opportunity appears, it’s off to the races. Competing arb bots try to outspend each other on gas fees, so their arb trade goes through first.
5. Statistical
Statistical arbitrage or “stat arb” uses computer modeling to take advantage of the inefficient pricing of securities. Put simply, you find lots of correlated or inversely correlated assets and make short-term trades on their price action.
For example, Pepsi and Coke are competitors, so when Coke stock declines, Pepsi stock declines. A stat arb trade would long Coke and short Pepsi simultaneously.
Stat arb modeling finds and tracks every Coke and Pepsi relationship in the market. Then the system opens delta-neutral trades on them at once.
In crypto, you could open positions on tokens competing in the same niche or utility space. You could also get creative with longing crypto and shorting banking or payment app stocks.
Many stat arb models in crypto look for correlated crypto tokens and open positions on laggards. Laggards are cryptocurrencies that haven’t experienced volatile price action when other correlated assets have.
Want to trade like a bot? Check out Pluto’s free auto-rebalancing tools that automatically enable your portfolio to adapt to the market.
How Can You Start Crypto Arbitrage?
Arbitrage trades are fleeting. You will need to screen a lot of tokens across many markets and protocols. Look for patterns in token flows and watch arbitrage bots.
Arbitrage comes from barriers to entry. Look for gated communities and protocols. This is probably the most accessible type of arbitrage.
For example, if a new crypto trading platform launches a beta program, you could join and compare all of the platform’s asset prices to external prices. The same goes for NFT platforms or even cross-chain NFT drops.
There are entire internet communities dedicated to finding arbitrage opportunities. Try searching Twitter or Reddit for arbitrage strategies.
Why Are Crypto Exchanges Considered Relatively Low-Risk?
If you’re arbitrage trading reputable crypto exchanges, such as Binance or Coinbase, you can be reasonably sure your orders will get placed and that the order books are accurate.
However, if you’re not in an open trade, you should self-custody your crypto, as centralized exchanges have a non-zero risk of failure. Look no further than the FTX fiasco, and you’ll know that you should research before choosing your exchange.
Other cryptocurrency arbitrage trades are more involved and involve several steps of blockchain and protocol hopping. But sometimes, the juice is worth the squeeze.
Different exchanges rely on regularly scheduled rebalancing services to maintain investing products like leveraged tokens or token baskets. You can find arbitrage trades by monitoring regular token rebalances and frontrunning them.
What Are the Dangers of Crypto Arbitrage?
Security Risks
There are thousands of potential market makers in the cryptocurrency ecosystem. So there are many potential trading pairs and instruments to find arbitrage.
However, if the prices look too good on a cryptocurrency exchange, it could be because their platform is insecure. The code could be malicious or downright buggy and drain your wallet. Many malicious NFT smart contracts attempt to empty your wallet by tricking you into signing.
Remember never to execute transactions on sketchy websites. And if you find a juicy arb opportunity, load up a burner wallet or account to test the trade before investing a lot of capital.
Fees
Sometimes, an arb opportunity that looks great on paper doesn’t work in practice. Hidden fees can ruin arbitrage strategies.
Exchanges charge trading fees and most blockchains charge transaction fees which can add up during a multi-step arbitrage trade.
Other fees you may consider when evaluating profitability are taxes. Taxes reduce the profitability of an arbitrage, especially if it’s multi-step and involves multiple crypto assets.
Time-Sensitive
Crypto arbitrage opportunities are rare, and due to the public nature of blockchain data, they disappear quickly.
Another way to take advantage of crypto arbitrage is with flash loans. Flash loans are loans you take from decentralized lending platforms and repay within one block of the blockchain.
Usually, flash loans are on a blockchain like Ethereum with programmable transactions and lending protocols. This means anyone can use a considerable amount of capital to exploit arbitrage.
You can make a million-dollar loan for a small fee, use the capital to exploit arbitrage, and then repay the loan. For this reason, even small arbitrage opportunities can be profitable. And as a result, flash loan users can quickly reduce any arbitrage trade to make it unprofitable.
Arbitrage may disappear if the liquidity of one of the trading pairs dries up. You might run out of time for an arbitrage trade sooner than you thought because one leg has low liquidity.
The Bottom Line
Arbitrage trades often are low risk and can be repeatedly exploited for profit. But true arbitrage is rare to come across in crypto. And when you find arbitrage, someone with more capital or an army of bots can exploit it.
But you can learn a lot about cryptocurrency markets by searching for arbitrage. Monitoring and thinking about how different markets and trading pairs fit together will often lead to better trading habits.
The other great thing about the crypto market is that there’s a niche for everyone. You can dive down the rabbit hole of gaming tokens or get into the weeds on over-collateralized lending.
With enough research, the odds are good an arbitrage opportunity can eventually fall into your lap. But most people don’t recognize these trades.
Successful crypto arb traders know all the exchanges and where derivatives are offered on tokens. They also know how to test arbitrage trades and tweak the trade to reduce fees.
Many arbitrage bots are trained on historical price data. So why aren’t your strategies? For more historical data and back-tested strategies, check out our free tools at Pluto.
Sources:
Statistical Arbitrage: Definition, How It Works, and Example | Investopedia
Delta Neutral: Definition, Use With a Portfolio, and Example | Investopedia
