What is arbitrage trading?

Arbitrage trading is a low-risk trading strategy where a trader profits from price differences across markets. In this strategy, the trader buys and sells the same asset (e.g., Bitcoin) on different exchanges. Since the price of Bitcoin on Binance and other exchanges should be the same, any difference between prices provides an opportunity for arbitrage.

This strategy was previously popular among large financial institutions but is increasingly gaining popularity in the trading world today. With the democratization of financial markets through cryptocurrencies, traders also have the opportunity to leverage the advantages of the crypto industry and apply arbitrage trading.

Introduction

What would a trade look like where you could guarantee a profit? Before entering a trade, you would need to know that you will profit. After all, anyone with such an advantage would use it for as long as possible.

While guaranteed profit doesn't exist, the closest thing to it is arbitrage trading. Traders compete fiercely for the opportunity to engage in such trades. Therefore, profits in arbitrage trading are usually small and depend largely on the speed and volume of each trade. Most arbitrage strategies are executed through algorithms developed by companies specializing in high-frequency trading (HFT).

What is arbitrage trading?

Arbitrage trading is a trading strategy aimed at making a profit by simultaneously buying an asset on one market and selling it on another. It most commonly involves arbitraging identical assets traded on different exchanges. In theory, the price difference between these instruments should be zero since it's the same asset.

However, for an arbitrageur, it's important not only to identify price differences but also to execute trades quickly because other arbitrage traders can also spot this difference, and the window of profitability will close rapidly.

It's also worth noting that arbitrage trades are generally associated with low risk and usually yield modest returns. To achieve greater profits, arbitrage traders need to make fast decisions and have substantial capital.

If you're reading this article, you're probably interested in the types of arbitrage trading used among cryptocurrency traders. There are several types of arbitrage trading in cryptocurrency. Let's explore them.

Types of Arbitrage Trading

There are numerous types of arbitrage strategies used by traders around the world on various markets. However, when it comes to cryptocurrencies, several types are most widely used.

Exchange Arbitrage

One of the most common strategies in cryptocurrency arbitrage trading is exchange arbitrage. In this strategy, a trader buys a cryptocurrency asset on one exchange at a low price and sells it on another exchange at a higher price. Cryptocurrency prices can fluctuate rapidly, so prices for the same asset on different exchanges almost never match. Arbitrage traders exploit these small differences to generate profits. As a result, the primary market becomes more efficient because prices across different exchanges remain within a relatively narrow range.

How does it work in practice? Suppose there is a price difference in Bitcoin between Binance and another exchange. An arbitrage trader wants to buy Bitcoin on the exchange with the lower price and sell it on the exchange with the higher price. However, timing and the speed of executing trades are crucial here. Since the Bitcoin market is relatively mature, exchange arbitrage is usually limited.

Funding Rate Arbitrage

Another common type of arbitrage trading among traders dealing with cryptocurrency derivatives is funding rate arbitrage. This means that a trader buys a cryptocurrency and hedges its price movement using a futures contract on the same cryptocurrency, where the funding rate is lower than the cost of buying the cryptocurrency. The cost of the trade in this case refers to any fees associated with the position.

Suppose you have a certain amount of Ethereum. You may be satisfied with this investment, but the price of Ethereum will fluctuate significantly. You decide to hedge your existing funds by placing a short futures contract for the same amount as your Ethereum investment. Let's say the funding rate for this contract is 2%. This means that by holding Ethereum, you will receive a 2% return without any price risk, creating an advantageous arbitrage opportunity.

Triangular Arbitrage

Triangular arbitrage is another common type of trading in the cryptocurrency world. In this case, a trader notices price discrepancies among three different cryptocurrencies and cyclically exchanges them for each other.

The idea behind triangular arbitrage is to profit from the price difference between currencies, such as BTC/ETH. For example, a trader may buy Bitcoin for BNB, then buy Ethereum for Bitcoin and exchange Ethereum for BNB. If the relative value of Ethereum and Bitcoin does not match their value in BNB, an arbitrage opportunity arises.

Risks in Arbitrage Trading

While the risk in arbitrage trading is considered low, it doesn't mean it's zero. Without risk, there is no reward, and arbitrage trading is no exception.

The biggest risk associated with arbitrage trading is execution risk. It arises when the price difference closes before the trade is completed, leading to zero or negative returns. This can be caused by slippage, slow execution, abnormally high transaction costs, sudden volatility spikes, and other factors.

Another significant risk of arbitrage trading is liquidity risk. It arises when you lack the liquidity to enter and exit markets and complete arbitrage. If you trade instruments with leverage (e.g., futures contracts), unfavorable market developments can lead to margin calls. Risk management is a key aspect of successful arbitrage trading.

Summary

Using arbitrage trading is an excellent opportunity for cryptocurrency traders to profit. If you have the speed and capital to engage in such strategies, you can quickly start making profitable trades with low levels of risk.

However, it's essential to consider the risks associated with arbitrage trading. Although arbitrage trading theoretically can provide "risk-free" or "guaranteed" profits, in practice, there are enough risks that can keep any trader on edge.