What Is Crypto Arbitrage and How It Works?

Crypto Arbitrage

With more than thousand cryptocurrencies and hundreds of crypto exchanges in the market, there are ample opportunities to earn through crypto arbitrage trading. 

One must wonder what is arbitrage trading and how to do it with crypto. This article contains everything there is to know about crypto arbitrage.  

What is Arbitrage trading?

Arbitrage trading refers to buying a security in one market and selling it simultaneously on another market at a higher price to gain from the price difference. Arbitrage trading was part of financial markets before crypto even came but the hype around crypto arbitrage is much more than arbitrage trading of other assets. This is because the scope of arbitrage trading is more in crypto as there are hundreds of exchanges active 24/7 in the crypto world. 

What is Crypto Arbitrage? 

Buying cryptocurrency from one platform at a lower rate and selling it on another platform quickly at a higher rate is called crypto arbitrage. For example, suppose if bitcoin is of $60,000 on exchange 1 and of $60,250 on exchange 2 then the trader can buy BTC from exchange 1 and sell it on exchange 2 to gain $250 in the process.

Is Crypto Arbitrage legal? 

Yes, Crypto arbitrage is completely legal. The activities of arbitrageurs help to maintain uniformity of prices across different platforms. Not only crypto but profiting from price differences of any asset on any market is legal. 

Types of Crypto Arbitrage strategies 

1. Cross-exchange arbitrage:

This is the most basic type of crypto arbitrage. Traders can buy crypto on one exchange and sell it on another exchange gaining from the price difference. This happens when he buys at a lower price from the first platform and then sells at a higher price on the second platform. 

2. Triangular arbitrage:

This kind of crypto arbitrage trading is done with three cryptocurrencies on the same exchange especially when the price of one digital currency has gone down momentarily. For example, a trader can create a cycle that starts with BTC (bitcoin) and ends with BTC. For instance, a trader buys BTC and converts it into ETH(ethereum), then converts the ETH into XRP(Ripple’s coin), then again exchanges the XRP for BTC. This is done in the hope of ending up with more BTC than in the beginning. In triangular arbitrage, the trader doesn’t have to withdraw and deposit money on different platforms as everything happens in one platform only. 

3. Spatial arbitrage:

This is similar to cross-exchange arbitrage but the exchanges are located in different regions. For example, gaining from the market inefficiencies demand and supply of bitcoin in South Korea and America. 

4. Statistical arbitrage:

This method is used for large scale crypto arbitrage trading by using stats, bots, data analysis, and computational techniques. Traders who use this method can gain profit on a larger scale. Trading bots used to do statistical arbitrage are automated trading mechanisms that are fed with pre-defined trading strategies. They are built to perform high volume trade at record time. 

5. Decentralized arbitrage:

This crypto arbitrage practise is common on decentralised echanges(DEXs) or automated market makers(AMMs). If traders see that the prices of a cryptocurrency on a DEX are significantly different from their prices on a centralised exchange then they can execute a cross-exchange arbitrage to earn a profit. 

How to take advantage of Crypto Arbitrage? 

Use less popular cryptocurrencies. Using bitcoin for crypto arbitrage may not be as effective for earning profits. Firstly because BTC transactions take 10 minutes to an hour to process and in this time the trader may lose the price difference as crypto prices are high;y volatile. Secondly because as BTC is a popular currency, its prices are mostly stable across different platforms.  

Use software that keeps track of different exchanges at once and reshuffles the portfolio as and when they note a price difference from which the trader can profit from. Arbismart, Pionex, Cryptohopper are examples of some crypto arbitrage applications that automate the arbitrage trading activities for the investors. 

Why is Crypto Arbitrage considered low-risk? 

Crypto arbitrage is generally considered as a low-risk strategy to earn profits. 

As arbitrage transactions last only upto minutes, investors are not exposed to trading risks. Trader can get out of it anytime if it is not generating profits. People don’t have to wait for hours or days to earn a margin while participating in crypto arbitrage. 

Crypto arbitrage is not dependent on predictive analysis so the traders don’t have to rely on future price rises to earn money on their investments. They don’t have to apply analysing strategies to do predictive analysis. 

But just as any other trading activity, crypto arbitrage is also not risk-free. There is a significant amount of risk involved in crypto arbitrage as well. 

Crypto Arbitrage trading risks 

1. Transaction fees:

When crypto is traded across different platforms it involves some transaction fees. For people who want to earn profits through regular crypto arbitrage, these fees can accumulate and eat the profits earned. To avoid such a situation, it is advised to buy and sell on exchanges that don’t have high transactional fees. Another way the risk of high transaction fees can be avoided is by depositing funds on multiple crypto exchanges. This will allow the traders to rebalance their portfolio whenever required. 

2. Hot wallet risks:

Traders need to maintain wallets with multiple exchanges if they want to perform crypto arbitrage trading. Keep in mind the hot wallet risks when doing this. Choose to trade on reputable exchanges to avoid such risks.  

3. Timing:

Arbitrage trading is all about timing. If buying and selling is not done fast enough then the opportunity to earn may vanish. As more and more traders try to gain from the price difference, the price may become uniform and those who are late in doing so would not earn a margin. To avoid this, traders should stick to blockchain networks that don’t take more than a few minutes to validate transactions. 

4. Security:

Crypto arbitrage traders are prone to security risks related to different crypto exchanges and exit scams. Traders often try to find exchanges that have no transaction fees or offer other high benefits, but they should stick to reputable crypto exchanges to avoid exit scams and security hacks. Exit scams happen when an exchange halts its operations and runs away with the investors’ money. 

5. Volume:

Some exchanges may put restrictions on the amount of cryptocurrency that can be withdrawn or deposited at one time. If an exchange has low volume then the trader might not benefit from a price difference. 

6. Taxes:

The IRS in the US has categorized crypto as property and treats the gains from selling it as gains from selling property. Cryptocurrencies have been classified as a form of security by the Securities and Exchange Commission. The Commodity Futures Trading Commission has called cryptocurrencies a form of commodity. With the rules of the government in mind, traders must account for any taxes that come with their income from crypto trading. 

Conclusion 

The crypto market is highly volatile and one can easily lose or win here. Seeing so many exchanges and cryptocurrencies may confuse the traders. Any activity related to crypto needs researching as it can get complicated for a beginner.

Crypto arbitrage has big chances of proving beneficial for traders. But before entering into any kind of trading activity one must analyse its risks before hand. Try exploring lesser known cryptocurrencies and automating softwares that help you to earn more profits while doing crypto arbitrage. 

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