In the previous post, we have learned that market makers are able to profit from the bid-ask spread but need to bear the risk of holding onto a large amount of assets. There is another type of traders – arbitrage traders whose trading strategy is known to be risk free.
What is arbitrage trading and is it really risk free?
There are now over 500 exchanges on the market and that number is growing. The price of an asset on different exchanges is not the same hence giving arbitrage traders the chance to profit from buying and selling the same assets in different exchanges. Given that the trader is merely buying and selling the asset simultaneously, they bear no risk.
While the strategy is a sure win, there are chances for arbitrage traders to lose money. Exchange fees are the major cost of arbitrage trading. There are chances for arbitrage traders to lose money if the profit they made from buying on one exchange and selling it on the other is not able to cover the fees.
Another risk is slippage-the difference between the expected price and the price the trade is actually executed at. While this is something all traders have to deal with, arbitrage traders are exceptionally vulnerable to such a risk since they profit from buying and selling assets simultaneously. A slight delay in execution could result in huge losses.
The different types of cryptocurrency arbitrage
Although arbitrage trading isn’t 100% risk free, it remains a popular trading strategy and here are two common ways on how it is done.
Fiat Triangular Arbitrage
The concept of triangular arbitrage is most commonly associated with price differences in foreign exchange markets. For example, a trader buys Bitcoin with USD, send it to a South Korean exchange and then sell the coins for Korean Won. Lastly, he converts the Won to USD for a profit.
Crypto Triangular Arbitrage
Traders can also take advantage of the opportunity to make a triangular arbitrage profit on the mispricing between three pairs of different coins. This mispricing can even occur on the same exchange.
Below is an example of the mispricing between the pricing of Ethereum, Litecoin and Bitcoin on a single exchange. The trader is able to gain more Bitcoins by making use of the mispricing between these tokens. Trading bots are becoming more and more popular and there are traders who designed bots that are able to take advantage of the mispricing the moment they happen.
Arbitrage traders eliminate price differences
There seems to be some negativity around arbitrage traders, describing them as opportunistic traders preying on loopholes in the market. However, let’s not forget one important outcome of arbitrage trading is eliminating price differences.
For example, the bidding price of Bitcoins at exchange A is around $3999 and the asking price is around $4001. On exchange B, the bidding price is around $4999, and asking price is around $5001. This means a trader is at risk of buying Bitcoins at a much higher price, if he or she did not check out all the prices on Bitcoins on different exchanges.
As such, here is an opportunity for arbitrage traders to make profit by buying Bitcoins from exchange A and selling it on exchange B. The first arbitrage trader to discover this opportunity is able to gain the most profit by buying Bitcoins on exchange A at $4001 and then sell it on exchange B at $4999, pocketing $998 in profit.
The next sell order in line on exchange A is $4002 and asking price on exchange B is $4998, giving arbitrage trades a $996 profit. As arbitrage traders continue to buy Bitcoins on exchange A and sell on exchange B (taking away the order with the highest asking price on exchange A and then taking away the order with the highest bidding price on exchange B), their profit margin will diminish and so does the price gap between the two exchanges.
When the arbitrage trader’s profit drop to a level which they no longer find appealing, they will stop trading. At this point, it is likely the bid-ask spread on the two exchanges is roughly between $4449 and $4501. The price gap between the two exchanges has been reduced from almost $1000 to around $2. If there are no arbitrage traders, traders are at risk of buying assets at higher prices.
Arbitrage trading may become less profitable in the future
Considering the fact that the cryptocurrency markets are still developing and less efficient than traditional markets, asset mispricing will occur. Opportunities to arbitrage are quite hard to come by in traditional financial markets because there are institutional traders that take up tiny opportunities in a relatively shorter period of time and ensure that these markets are kept efficient. AAX believes cryptocurrency markets will have similar support sooner rather than later.
As cryptocurrency markets continue to mature, more traders and institutional traders will take advantage of arbitrage. As such, the potential profits will diminish.
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