Arbitrage Trading: Complete Guide
Arbitrage trading involves making profits off market price discrepancies, but there are many strategies to pick from. Learn everything you need to know in our arbitrage trading guide covering arbitrage trading strategies, arbitrage trading bots, arbitrage trading taxes, and more.
What is arbitrage trading?
Arbitrage trading is a strategy that leverages temporary price differences of the same or similar assets in different markets to make a profit. Traders, known as arbitrageurs, buy low in one market and sell high in another—often simultaneously. Although often considered a risk-free strategy, it comes with its own set of challenges, including transaction costs, execution risks, and liquidity issues.
How does arbitrage trading work?
At its core, arbitrage exploits inefficiencies in the market. For example, suppose you notice that a stock is trading at $20 on one exchange but is listed for $20.05 on another.
By buying at a lower price and selling at a higher price, you can earn a quick profit. While these differences are often small, they add up, especially for traders who conduct multiple transactions or use substantial capital. Arbitrage works quickly; once an opportunity is identified, markets usually adjust, making it a short-lived event.
Arbitrage plays an important role in maintaining market efficiency by pushing prices of the same or similar assets closer together, thereby correcting mispricings. In the digital age, arbitrage is often powered by sophisticated algorithms and high-speed trading systems to catch opportunities in fractions of a second.
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Different arbitrage trading strategies
Simple or pure arbitrage
This involves buying and selling the same asset across different markets at the same time to profit from price discrepancies.
Example: Buying a stock at $100 on one exchange and selling it at $101 on another exchange for an instant $1 profit per share (before fees).
Merger arbitrage
Also known as risk arbitrage, traders buy shares of a company that is being acquired and bet on whether the deal will go through.
Example: If Company A offers to buy Company B at $20 per share, and Company B’s shares are trading at $18 due to uncertainty about the deal’s completion, a trader might buy shares at $18 hoping to sell at $20 once the deal closes.
Convertible arbitrage
This strategy focuses on the price differences between a company's convertible bonds and its common stock.
Example: If a bondholder believes a convertible bond is undervalued relative to the stock, they may buy the bond and short the stock to capitalize on expected price movements.
Triangular arbitrage
This involves converting one currency into another, then into a third, and finally back to the original currency to exploit pricing discrepancies.
Example: Convert USD to EUR, EUR to GBP, and GBP back to USD. If there’s a difference in conversion rates, you can lock in a profit.
Statistical arbitrage
This strategy uses quantitative models and big data analysis to identify price discrepancies between related securities. It's common among hedge funds and algorithmic traders.
What’s crypto arbitrage trading?
Crypto arbitrage trading takes advantage of price differences in digital assets across different exchanges. The crypto market, known for its high volatility and round-the-clock trading, presents frequent arbitrage opportunities.
Example: Imagine Bitcoin is trading at $45,000 on Coinbase but $45,200 on Kraken. A crypto arbitrageur buys Bitcoin on Coinbase and sells it on Kraken, pocketing the $200 difference (minus fees).
Why do price differences occur in crypto markets?
Crypto arbitrage has gained significant attention due to the decentralized and often fragmented nature of the market. Prices can vary widely across different exchanges, creating numerous opportunities for savvy traders. The reasons for price differences include varying liquidity, demand, and market access across exchanges.
For instance, decentralized exchanges often use automated market maker (AMM) systems to determine asset prices, relying on liquidity pools funded by user contributions. These pools can result in price discrepancies compared to centralized exchanges, creating opportunities for decentralized arbitrage. On centralized exchanges, the price of a cryptocurrency depends on the most recent matched orders on their order books. Price differences may arise due to differing demand and supply dynamics.
Common strategies include cross-exchange arbitrage, where a trader buys an asset on one exchange and sells it on another; triangular arbitrage, where the trader moves between three different cryptocurrencies to exploit price differences; and statistical arbitrage, which uses algorithms to detect market inefficiencies.
Read next: What Determines the Price of Crypto?
Examples of crypto arbitrage
Cross-exchange arbitrage example: A trader notices Bitcoin trading at $50,000 on Exchange A but $50,300 on Exchange B. Buying on A and selling on B results in a $300 profit (minus fees).
Triangular arbitrage example: Convert BTC to ETH, ETH to ADA, and then ADA back to BTC. If price discrepancies exist, the loop can end with more BTC than you started.
What are the benefits of arbitrage trading?
Low risk: True arbitrage opportunities are generally considered low risk as they rely on price differences that often result in near-instant profits.
Market efficiency: By eliminating price discrepancies, arbitrageurs contribute to fair pricing and efficient markets.
Increased liquidity: Arbitrage trades often boost market liquidity, benefiting all market participants.
Income diversification: Traders can diversify income by engaging in multiple types of arbitrage strategies.
What are the risks of arbitrage trading?
Transaction costs: Trading fees, withdrawal, and deposit costs can quickly erode potential profits.
Execution risk: Delays in trade execution due to system lag or market conditions can impact profitability.
Liquidity risk: Large trades can affect market prices, making it challenging to execute orders without significant slippage.
Model risk: Algorithms used for arbitrage might fail during unusual market conditions.
Regulatory risk: Changes in market regulations, such as those affecting cross-border transactions, can impact arbitrage strategies.
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What tools can be used for arbitrage trading?
Modern arbitrage trading heavily relies on technology. High-speed trading bots can execute trades in milliseconds, monitoring multiple exchanges and markets for opportunities. Access to real-time data feeds and algorithmic models helps traders stay ahead in this highly competitive field.
Arbitrage trading bots
Looking for a crypto arbitrage trading bot? Some popular options to research include:
Cryptohopper: Established in September 2017, Cryptohopper offers two arbitrage strategies—triangular and market arbitrage—across more than 15 major exchanges. The Hero subscription, priced at $129 per month, provides access to the arbitrage bot features. While the initial setup may be challenging for beginners, the platform offers a variety of pre-made templates to ease the process. Cryptohopper also has an active community, particularly on Discord.
Coinrule: Launched in 2017, Coinrule is recognized for its user-friendly interface, making it ideal for traders without extensive coding knowledge. It provides customizable templates for easy setup of arbitrage strategies. The free version is quite limited and only up to $3,000 in volume, with paid plans starting from $29.99 a month. Supporting over 10 exchanges, including Coinbase and OKX, Coinrule is a solid choice for newcomers to arbitrage.
Pionex: Since its inception in 2019, Pionex has gained popularity for its user-friendly approach, featuring a unique spot-futures arbitrage bot that enables trading in both spot and futures markets. The platform is free to use but charges a 10% fee on profits generated by the arbitrage bot. Users appreciate its ease of use, though managing trade data for tax purposes can be complex due to high transaction volumes.
Read next: Best Crypto Trading Bots
How to start crypto arbitrage trading
DYOR: Understand market dynamics, fees, and risks involved.
Choose the right platform: Use exchanges with competitive fees and fast transaction times.
Automate the process: Consider using trading bots or software designed for arbitrage trading.
Manage risks: Keep an eye on transaction fees, liquidity issues, and market volatility.
Arbitrage trading, especially in the crypto market, offers opportunities for quick profits by exploiting temporary price differences. However, it requires significant skill, quick execution, and sometimes substantial capital to make it worthwhile.
Don’t forget the tax bill…
Arbitrage trading comes with a tax bill. If you’re crypto arbitrage trading, Koinly can help you track your trades, profits, and losses - all free of charge. Sign up free today.
