What Is Arbitrage and How Is It Used in the Coin Market?
The Merriam-Webster dictionary defines arbitrage this way:
The near simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies.
Let’s break that down further and also understand how arbitrage strategies are used in the cryptocurrency market.
A Simplified Explanation of Arbitrage
Arbitrage is considered a no-risk profit strategy when executed against traditional financial instruments. Why? Because you are buying an asset and selling it simultaneously for a higher price at a profit. It’s considered no risk because there is no hold time or delay between the transactions and the profit is guaranteed.
This type of transaction can be completed with any asset type, but typically the assets are bonds, stocks, currency or other financial instruments.
Here’s a simplified example. A stock is trading for $10 in the New York Stock Exchange (NYSE), but is trading on the Tokyo Stock Exchange (TYO) for $11. You would buy the NYSE stock at the lower price and simultaneously sell the stock in the TYO, making a $1 profit per share.
Because of automated trading systems and high-frequency trades it’s rare for this sort of price discrepancy to occur, making it rare for arbitrage trades like this to happen. Today, when these discrepancies are noticed, they usually only last for a short window of time, measured in seconds or even microseconds. High interest in the “cheap” stock raises its price and subsequently drives down the price of the “expensive” stock. Even before automated trades, arbitrage was viewed as a mechanism for maintaining equilibrium across markets.
What Does Arbitrage Have to Do with Cryptocurrency?
Unlike the stock market, the coin market is ripe for arbitrage. Cryptocurrency don’t support high-frequency trading, which means there are fewer automated trading robots controlling or responding to price fluctuation. There are fewer pressures or controls to ensure pricing equilibrium across exchanges. Also, when new exchanges open, they offer an opportunity to buy in a more established exchange to sell at a profit in the new exchange.
If you plan to pursue arbitrage as a trading strategy, there are three things you must consider:
- Fees. This can include trading fees, withdrawal or deposit fees, and blockchain fees. You have to calculate if the fees you incur will eat the profit that you anticipate making.
- Time. Rarely do trades happen simultaneously in the coin market as they can in the automated stock exchanges. You have to weigh the risk that you’ll miss the pricing window if a trade is slowed down for some reason.
- Risk. Arbitrage in the stock market is considered no risk. Because of the time and fee considerations mentioned above, arbitrage in the coin market is hardly a no-risk venture.
What Do You Need to Profit from Coin Arbitrage?
Reliable information about cryptocurrency is one of the most valuable assets you can possess. In this relatively new market, it’s also one of the hardest assets to find.
If you plan to use arbitrage in the coin market, what information and tools should you look for?
- Rates: To benefit from arbitrage, you’ll need to know current rates of exchange. Seek out information sites that provide up-to-date coin prices.
- Opportunities: Try to access a service that can send alerts about potential opportunities. Alerts can help you act on opportunities before other traders do.
- Simulations: Success in the coin market relies on creating and executing smart trade strategies. Simulation tools can help you validate and improve your trade strategies.
- Bots: Automation helps traders stay on top of market changes. You can use bots set up to take specific actions based on limits that you set.
You may need nerves of steel to execute coin arbitrage, but having reliable, credible information should remove at least some of the guesswork.