Crypto arbitrage? Perhaps you are thinking that this sounds like something mysterious that you do undercover, like a secret trade. While that does sound intriguing, we are actually talking about using arbitrage to trade on price differences in cryptocurrencies. Yes, we said arbitrage, not espionage.
If you are already a trader, you are probably familiar with the term arbitrage. Essentially, it means the simultaneous buying and selling of an asset on different markets to take advantage of the price difference of that asset.
In the case of cryptocurrency arbitrage, we are taking advantage of the fact that a cryptocurrency can trade at different prices on two different exchanges. We can potentially exploit that difference to make money by buying low on one exchange and selling high on a different exchange. For example, if a trader buys $100 worth of coin on one exchange and sells it for $150 on another exchange, he has made a quick 50% profit with relatively low risk. Yes, it’s the old “buy low, sell high” adage of trading.
What is Arbitrage?
The term arbitrage in trading refers to a strategy of selling assets in order to take advantage of price differences between varying exchanges.
What Makes Crypto Arbitrage Possible?
We are all familiar with the use of arbitrage in the stock, bond, and foreign exchange markets. The concept is nothing new. It has been in existence for many years. Arbitrage opportunities exist because of inefficiencies in the market. Generally, those inefficiencies are caused by supply and demand fluctuations.
Arbitrage allows those fluctuations to work itself out so that an equilibrium price is reached. When an asset has a low price on one exchange, the demand for that asset will increase, causing the price to rise. Selling that asset to another exchange with a higher price will cause the price of that asset to fall. In this way, prices will roughly equalize.
Inefficiencies in the Market
For cryptocurrencies, inefficiencies exist for a multitude of reasons. There are over 200 cryptocurrency exchanges in the world, but they are not synchronized. Most operate independently and don’t share information with each other. Larger markets with higher liquidity tend to drive the price of the rest of the market. Smaller exchanges tend to follow the price movement of the larger exchanges. However, their lower trading volumes mean that they don’t immediately reflect the new price. Because cryptocurrencies are volatile, prices can rise and fall quickly. These price variations can create arbitrage opportunities.
Market inefficiencies may also arise from high demand. Sometimes this demand is created by extreme economic and political conditions. One example of this is the high demand for bitcoin in South Korea. The result? The “kimchi premium”. In December 2017, this premium was more than 40% higher than exchanges in the U.S.
Other examples of high demand include Hong Kong where bitcoin has traded at a premium as a result of political unrest. And Zimbabwe, a country with hyperinflation, where consumers were unable to access exchanges outside of their country.
Other inefficiencies in the market may be caused by fluctuations in currencies which may cause crypto to be undervalued on foreign exchanges and asymmetrical information between buyers and sellers. Also, because cryptocurrencies are still in their infancy, fewer traders and less competition can create arbitrage opportunities.
Ways to Profit From an Arbitrage Opportunity
What are some ways to take advantage of arbitrage? There are a number of strategies which can be used to make a profit including:
Simple or Spatial Arbitrage Trading
Buy and sell the same coin simultaneously on separate exchanges with significant price differences.
This is similar to spatial arbitrage except that the two exchanges are located in different countries. Depending on the countries, this may be a little harder to execute as KYC (Know Your Customer) regulations can place barriers on entry to many exchanges. For instance, you may need to hold a bank account in the country in which you wish to trade. As well, it may take time to verify your account before you can start trading.
Take advantage of price differences between three currencies on the same exchange, and profit on the conversions. For example, you could buy BTC in USD, sell BTC to buy ETH, and convert ETH back to USD. To profit from this strategy, fast reaction times to market fluctuations are necessary as well as low transaction costs.
Buy a coin on one exchange where it is undervalued, and short-sell the coin on another exchange where it is overvalued. When the two prices meet at a middle point, you can profit from the amount of convergence.
This involves trading large diverse portfolios on a very short term basis, using complex mathematical modeling.
How To Do It
Selecting the exchanges on which you will trade is a crucial first step. In order to proceed with crypto arbitrage, you will need to be registered on a few exchanges and have your funds ready to go. Some, like Bitfinex, require a minimum deposit of $10,000 in order to start trading.
It is better to be all set up before you start, as some exchanges will take time to verify your information. As we’ve stated earlier, arbitrage opportunities are generally short-lived. Being nimble is key. Any delays in your transactions can turn a profitable trade into an unprofitable one.
To set up an account, you will generally need to comply with the KYC (Know Your Customer) and AML (Anti-money Laundering) regulations of the exchange. KYC regulations are stringent requirements that require a trader to provide valid government-issued identification or other documentation as proof of their identity. This verification process can sometimes take days or weeks to complete.
Finding the Best Exchanges
In evaluating which exchanges are best suited to your purpose, this crypto arbitrage guide suggests that you consider the following variables:
Fees. Trading, deposit or withdrawal fees can make or break the deals. Go for low fee exchanges whenever possible.
Geography. Some exchanges or some of their features may be restricted or limited in your area, so you need to be aware of it before making a trade.
Reputation. Check out user reviews of the exchanges that you are interested in. There are many shady and unregulated platforms in the industry. Do your own research beforehand to ensure you are only dealing with reputable sites.
Transaction Times. Some blockchains allow for quick transactions while others can take up to an hour or more during peak times.
Withdrawal Times. Some exchanges make manual fund withdrawals which occur only once a day or so, so be aware and understand the rules before entering one.
Account Verification. Some exchanges may not allow you to withdraw funds or fully use the markets before you verify your account. This may take several days or weeks at a time.
Market Liquidity. Not every exchange has enough liquidity, especially if you’re looking to buy or sell large quantities of digital assets.
Wallet maintenance. Wallet maintenance occurs when a wallet is disabled to prevent users from depositing or withdrawing from a wallet that may not be functioning properly. Most arbitrage opportunities occur due to wallet maintenance in certain exchanges, so be aware of whether you can withdraw or deposit the crypto assets of your choice.
Identify the Opportunity
Arbitrage opportunities can be identified by monitoring the markets for price differences, then placing your trade. This can be done manually, but would likely require a lot of time and effort on your part. Advanced traders make use of APIs (application programming interfaces) provided by exchanges to write their own algorithms. These will then execute the trade automatically when an opportunity is found.
If that is too complicated for you, there are also a number of cryptocurrency arbitrage bots available online. These however are not foolproof and come with their share of risks. For instance, bots can’t take into consideration factors like fundamental analysis, breaking news, or insider knowledge or the many other other factors that can influence a market. In using bots, you also leave yourself open to the possibility of scammy developers or flash crashes in the market. If you do decide to test them out, do your research and only use money that you are willing to part with.
Will The Trade Be Profitable?
Having found some potential opportunities, you must now decide whether you can make a profit on the trade. Some things you might want to keep in mind are:
Most crypto exchanges will charge fees for transactions and possibly deposit and/or withdrawal fees. These fees need to be factored in when determining whether there will be a profit left at the end of the trade.
Withdrawal and Transfer Times
Another thing to keep in mind is the delays that can occur with making withdrawals. Because of the volatile nature of cryptocurrencies, any delays may mean a missed opportunity by the time the trade is completed.
With the growing popularity of cryptocurrencies, some exchanges have found it hard to keep up with the demand. Slow transaction times can result when the network becomes congested. You may also want to give consideration to which coin you will be trading. Bitcoin will have longer transaction times, so consider trading in a coin with faster processing times like Ether (ETH).
When it comes to arbitrage, the profits can be quite small after you account for all the fees and processing delays. You must trade in large volumes in order to magnify the profit and make the trade worthwhile. However, you must consider whether an exchange has a limit on how much you can withdraw from your wallet per day. This will determine whether or not you can make a profitable trade.
At the end of the day, it is easy to forget that you will need to pay taxes on all your trades. How crypto is treated will depend on where you live. For example, in the U.S., cryptocurrencies are considered to be property. Every time you sell your crypto, you will incur a capital gains tax. In other countries, crypto may be treated differently. If you are planning to trade in different countries, this may be something to keep in mind.
Potential Pitfalls of Crypto Arbitrage
Having considered all the factors that may weigh on the profitability of the trade, you’re ready to take the plunge, right? Well, not so fast. There are some potential pitfalls of trading in crypto that you must consider.
Same Name, Different Coins
There are over a thousand coins out there and some have very similar, if not identical, names or symbols. This is actually a common problem that can end up costing you a lot of money if you are not careful. Exchanges will not refund your money if you send the wrong coin to the wrong wallet.
As an example, on Binance, the symbol CMT represents the CyberMiles currency, whereas, on the Crytopia Exchange, CMT is the Comet currency. As another example, HNC is the symbol for the HellenicCoin on LiveCoin exchange. On Coinexchange, it is the symbol for Huncoin. Confusing, right?
This is where you might need to exercise caution when relying on bots to find your trades. Don’t expect to see a price difference of 50% from one exchange to another. If it’s too good to be true, it probably is. One way to verify that you are talking about the same coin is to check the actual coin logo to make sure they match with the name. You can also look at the price and volume to see if it looks reasonable.
You must ensure that the coin you are trading has sufficient volume. Otherwise, you might find yourself stuck with a coin you can’t get rid of. Also, it is important to look at the bid/ask price, and not just the last price it traded at. There may be no volume at the price that you are looking to trade at. Check the coin’s volume per day, as well as per transaction, to get an idea of how the coin trades. If neither is sufficient, it is best to avoid that coin altogether.
Pump and Dump (P&D) Schemes
The world of crypto is still largely unregulated so it is not uncommon for suspect activities such as the P&D scheme. In this case, the price of a coin is artificially inflated through false and misleading statements or price action, so that it can be sold at a high price. The unsuspecting buyer is then left “holding the bag”, so to speak, when he is unable to resell the coin for anywhere near the price that he paid. That is why to be successful as an arbitrage trader, you must use technical analysis to evaluate the coin you are interested in.
Again, because of the unregulated nature of exchanges, it is not uncommon for an exchange to hold your funds indefinitely without explanation. Or it can even be on the pretense of needing more information from you to release the funds. Some exchanges have just shut down for good without returning investors’ money. Others may block certain countries from trading on their platform. Still, others have been subject to hacking due to poor security. It can be a moving target. Always proceed with caution by making a small transaction first, and doing your research when selecting an exchange.
A transaction may fail to go through due to issues on the exchange. Some of these issues may include exchange “overload”, “transaction could not execute”, wallet issues, withdrawal issues, exchange down, and many others. Again, it may be prudent to start off with a small transaction or break a big transaction into smaller ones to mitigate risk.
It is important to remember to take into account all fees, currency exchange rates, taxes, etc. when placing a trade. In the end, the profits may be so small that it is not worth the effort. This may be why most arbitrage trading is carried out by hedge funds and “whales” with deep pockets. Though crypto arbitrage is still relatively new, we are starting to see more hedge funds enter the market. The increased competition may make it even harder for a small investor to make a profit.
Is Crypto Arbitrage for You?
The volatile nature of cryptocurrencies makes it ideal for arbitrage opportunities. However, though crypto arbitrage may seem like a no-risk trading strategy, there are actually many risks attached. You must overcome legal, technical, and financial hurdles before you can begin trading. You must account for any fees, taxes, and exchange rates that will eat into your profit. On top of that, you must be mindful of shady, unregulated exchanges, and “scammy” bots. When all is said and done, the small profit at the end may not be worth all the effort. For the small investor, who has limited funds and access to sophisticated technology, this strategy may be somewhat out of reach. It may be something that is best left to the more advanced trader or the institutional investors.
That’s not to say that there aren’t crypto investment opportunities for small investors. If you are looking to trade side by side with the pros and benefit from their expertise, consider checking out hedgetrade.com.
As always, the information contained in this article does not constitute investment advice or expert opinion. Always consult with your investment advisor before proceeding. Remember to do your own research, and only invest with money that you can afford to lose. Happy investing!!