Trading Toolkits

Trading Toolkits: Arbitrage Trading Explained

No matter the trading style or strategy deployed, there exist some elements of risks. However, arbitrage trading is the “safest” form of trading where profit is wholly guaranteed when mastered.

Maybe you’re opposed to the high-risk option of trading stocks, forex, crypto, using spot or futures markets. Suppose you’re looking for a relatively stable, low-risk strategy to explore trading assets for profit-making; arbitrage trading does just this. Arbitrage opportunities give room for low-risk trades in a semblance of stability. They provide an almost guaranteed return on trades. However, regardless of the guaranteed nature of arbitrage opportunity, there are still some risks involved in all strategy types. Since there is no perfect system or strategy, minimizing such risks becomes crucial for a profitable trading experience.

What is Arbitrage Trading?

Arbitrage is the trading system that involves taking advantage of price discrepancies across different assets in different markets or exchanges. Volatility in the market exists as price changes at different times of the day. It is what ensures that an asset is overvalued or undervalued. Same for the stock market, which can maintain a stable price level for a longer duration than other asset classes like forex and cryptocurrencies. Volatility in the market is an opportunity for profit or loss incurred by traders in the market. 

Due to volatility, the market price may not be the same for the same asset across different exchanges. Arbitrageurs take advantage of this price difference with large volume and high transaction speed. The returns are, therefore, swift.

Different types of Arbitrage opportunities exist in the market for various asset classes. Identifying the specific type and applying the arbitrage principle will most certainly guarantee an almost risk-free return.

Different Types of Arbitrage

  • Cryptocurrency Arbitrage: Price fluctuation occurs with the different markets in the cryptocurrency market. For example, when a currency is trading lower on exchange A, traders can buy to sell on Exchange B, where the price is slightly higher. Sometimes, a cryptocurrency arbitrage opportunity is determined by the amount of liquidity involved and the fees incurred.
  • Triangular Arbitrage: Let’s say you are not comfortable moving funds around different exchanges due to the cost. You just want to take advantage of an asset with different values. Triangular arbitrage works with a single asset having a different value across other pairings. For example, a trader can buy BNB with his BTC, then buy ETH with his BNB, finally, he can buy back BTC with the ETH in a type of price loop, which happens in seconds. He profits by taking advantage of the discrepancy in value across the different assets.
  • Index Arbitrage: This type of strategy exploits the price discrepancies between two or more market indexes by buying a lower price index and selling at a higher index with a profit-making target. Theoretically, index arbitrage opportunities are present in the difference between the spot and the asset’s future price. These indexes trade on multiple exchanges offering arbitrage opportunities.

Regardless of the type of market, an arbitrage opportunity is always available. There are principles in practice and theories that give a guide as to how an arbitrage opportunity works.

Mechanics of Arbitrage

With the proliferation of exchanges on the crypto market, there are extensive arbitrage opportunities. An arbitrage opportunity is present when there is a difference in an asset’s price at a different exchange. For instance, if Bitcoin at Binance exchange sells for $48,000 and at a buy price of $47,800 in Kucoin exchange, an arbitrage opportunity is present d.  A trader who can quickly move funds around to fill in the discrepancies in price will receive the difference. Depending on their volume, they can take advantage of the $100 price difference and make a significant gain.

Significance of Arbitrage

There is no vacuum in price movements in the trading world; any such opportunity is filled quickly. Because of its rarity, it requires a high degree of speed and volume to profit in the real sense. In reality, arbitrage trading ensures the balance in the price of an asset across exchanges. Due to this practice, we can have the stability and sameness of an asset’s price across different exchanges. This is also the reason for equality in price value across other assets or trading pairs.

Even though this could guarantee a profit in a relatively short period and a pretty fast way, some risk elements exist. Traders should take into account such risks before engaging the strategy.

The Risks Involved in Arbitrage

  • Transaction Fees: Before taking an arbitrage opportunity, first look at the transaction costs at the different exchanges that the assets are listed. Transaction fees can wipe out all profit made when it’s high or unstable. Different exchanges offer different transaction fees; take note of this before engaging in arbitrage trade.
  • Low Liquidity: Sometimes, volatility in the market occurs because of high or low price impact in different exchanges where a particular asset is listed. Price impact is caused by liquidity existing or non-existing in a pair. This means that if there is no liquidity for an asset in an exchange, users will be unable to trade it—this results in stuck funds. Always check for the volume present in an asset before engaging or moving funds.
  • Bot Trading: Algorithm trading is common with this market strategy. Many times you are competing against a High-Frequency Trade (HFT) bot. Human traders do not possess a bot’s unique ability, enabling them to read price and take action in seconds. Essentially, if you’re not fast, you won’t be profitable.

In Closing

No matter the trading style or strategy deployed, there exist some elements of risks. Knowing these risks involved and finding ways to navigate through them will improve your profit-making potentials. However, arbitrage trading is the “safest” form of trading and almost wholly guaranteed. If you want a practically risk-free trading strategy, arbitrage trading is one for the taking.

Education before trading is a vital principle of the trading journey. Ensure you understand the concept of trading before engaging in one. Understanding trading styles and systems will reduce future losses significantly. As always, do your research.

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