You’ve probably heard of arbitrage before. It involves the purchase and sale of identical assets at the same time. By taking advantage of the market inefficiencies, traders will able to make profits by using the price mismatch.
In a word, arbitrage involves making a risk-free profit from pricing discrepancies. Today we are going to introduce several popular methods of arbitrage in cryptocurrency markets.
Arbitrage in spot trading
1. Cross-market hedge arbitrage
It is also called direct arbitrage. It is making a profit by using the price mismatch of the same trading pair (Such as BTC/USDT) buying and selling in multiple exchanges. As we know, there are thousands of crypto exchanges worldwide with the same trading pair and there’s always a price difference. The entire process of this arbitrage trading includes:
Buy x crypto asset at the exchange with the lower price withdraw it to the exchange with the higher price after the withdrawal transaction confirmed by the blockchain and the exchange, sell the crypto asset.
It’s worth mentioning that the risk here is that it can take a long time sometimes for the withdrawal transaction to be confirmed. The price of the asset which used to be higher can vary much during the process which kills the expected profits.
Traders should also take the fees during the process into consideration, such as withdrawal fees, trading fees. The profit brought by the price mismatch needs to be able to cover the fees to stay profitable.
A solution to improve the efficiency of this arbitrage is holding the asset on both trading platforms. For example, the price of bitcoin is $7000 on platform A and $7100 on platform B. You purchase one bitcoin on A and sell one bitcoin on B and in this way, the total crypto asset you are holding doesn’t change, however, you made $100 profit.
By holding crypto assets in the platform beforehand, the time of the withdrawal process is saved, making sure you are taking instant actions when the price difference reaches the peak. However, you need to search and identify the two platforms that may have this mismatch.
2. Triangular arbitrage
It is also called indirect arbitrage. It is making profit by the price mismatch of three different but related trading pairs on the same or different platforms. For example, the price of three trading pairs regarding EOS, ETH and USDT are listed below.
EOS/USDT = 5，
EOS/ETH = 0.02，
ETH/USDT = 275
By using the first and second trading pairs, we can get ETH/USDT = 250, lower than the third trading pair, so there’s a price mismatch for arbitrage. We can invest 250 USD to purchase 50 EOS with the first trading pair and exchange it to 1 ETH with the second trading pair. Then sell the ETH with the third trading pair so that we can make a $25 profit.
Similarly, among the arbitrage on different platforms, you need to consider the withdrawal time and fees. It is a lot easier to arbitrage within the same platform, but the price mismatch may not be that much.
Another type of price mismatch that can be used for arbitrage is the price difference between the spot trading platform and the futures platform.
Generally, when the market is in a sudden uptrend, the price of an asset in the futures trading platform will be higher than the spot platform, while when the market is dropping quickly, the price of futures will be lower than that in the spot. There is a tendency for the spread between the two to go down to zero. So, investors can use this trend to arbitrage.
When the price gap between the futures trading platform and the spot trading platform is positive, then a trader could open a short position on futures and buy the asset on the spot markets as an arbitrage strategy.
In crypto derivatives trading platform, especially for perpetual swap contracts markets, a mark price is used to control the spread between spot and futures markets. So only when extreme market conditions take place that traders are able to find a good opportunity to realize spot-futures arbitrage.
Arbitrage sounds to be an easy and risk-free way to make a profit. However, it requires accurate calculations and seizing the right timing. People are usually using software to set up their strategy and let the computer language to strictly follow the preset rules and conduct multiple trading actions real time.