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Arbitrage is described as a trading technique that exploits price differences of one asset between various independent brokers and exchanges. This form of trading is possible since every exchange has a slightly different supply/demand ratio.
The existing difference in prices is frequently found between local exchanges. Hence, it is linked to the economic situation in the jurisdictions where these exchanges are based. Furthermore, the exchanges have different processing capacities. That means the smaller exchanges will usually lag behind the larger ones which creates extra opportunities for profit.
The primary difference between the cryptocurrency and traditional markets, volatility, also plays an integral role too. Analysts discovered that the extreme volatility that exists in the crypto market significantly results in price differences that can be exploited for profit.
Crypto Exchange Arbitrage
This trading method is a common example in the crypto world. Whenever a trader spots a price difference between exchanges, they can get an asset at a lower price and sell it at the exchange where its price is higher. This mechanism also works the other way around.
Nevertheless, most traders are usually aware of this difference which makes such a trading mechanism an urgent matter. Traders must act quickly because the prices are quick to even out. Moreover, the service fees must be put into consideration because the price difference is normally small.
These factors may eat the profit margin making it extremely low and may not cater to the extra commissions on these trades. This arbitrage trading method is further divided into cross-border and spatial methods that have the same procedure. But, in the cross-border arbitrage, the participating exchanges are situated in different jurisdictions and countries.
Triangular Arbitrage
This trading method features the word triangular in its name because it is easier to visualize the algorithm by cracking it logically into three steps. For instance, if a trader wants to work with bitcoin, they can sell Bitcoin for ETH (ETH/BTC). Then, they can sell ETH for Bitcoin Cash ((BCH/ETH) and finally change Bitcoin Cash back into Bitcoin (BTC/BCH).
Hence, in the case of triangular arbitrage, to get a profit while assuming low transaction costs, traders must use a discrepancy between three foreign currencies. That happens when exchange rates do not match up.
Exchange-Broker Arbitrage
Whenever the price difference of a digital asset between a broker and an exchange increases during impulse movement, traders can concurrently buy the asset on the exchange and sell it at the broker and vice versa.
After the price difference goes back to the normal value, the profitable trade value becomes higher than that of the lost trade. In the end, it yields an overall profit.
Statistically, some of the crypto traders use software that automatically tracks the price differences between exchanges. The software offers profit opportunities that are timed precisely. On one hand, using this software widens the possibilities for the trader. On the flip side, it is associated with high risk as a result of the precision needed for profitable trades.
Is it worth using arbitrage with cryptocurrency?
Arbitrage has a great potential for profit and is accessible to a majority of the traders. Also, this trading method can be scaled up efficiently. Nevertheless, to make a consistent profit using the arbitrage method, the trader needs to continuously monitor the exchanges and the general market situation.
The competition is high in this trading method just like it is in all the other methods. Thus, traders must identify opportunities and act fast before the price difference evens out. Due to that, traditional arbitrage in the cryptocurrency market may become obsolete. However, it can still be used for now with the correct skills and software.
A low initial investment makes it even more challenging to gain any profit since the trader must also pay attention to commission values to ensure that the executed trades are profitable. Some of the virtual tokens also have low liquidity which makes it challenging to execute concurrent trades essential for arbitrage. That is the case mostly because many traders will likely be trying to do so at the same time.
In spite of these challenges, arbitrage is still a popular strategy of trading in the crypto market. It is gaining popularity as new peer-to-peer services coming in to connect traders from multiple countries for easier cross-border trades.