Understanding Crypto Arbitrage Trading

This article will explain all about crypto arbitrage trading, including how it works, types, and risks.

Are you looking for methods to make low-risk profits in the cryptocurrency market? If so, an arbitrage crypto trading strategy might be the right option for you.

Crypto arbitrage trading is a strategy that involves buying a cryptocurrency on one exchange and selling it on another exchange at a higher price. This is possible because different exchanges can have different prices for the same cryptocurrency. 

Such trading is essential in cryptocurrency as it helps keep prices accurate. When you, as a trader, identify and exploit price discrepancies, you help bring the prices on different exchanges into alignment.

This article will explain in detail how arbitrage trading functions in cryptocurrencies and why and how you can use it for profit. 

How Crypto Arbitrage Works?

Let’s understand the working mechanism before diving deeper into arbitrage cryptocurrency trading. The basic principle behind this strategy is that it profits from price discrepancies of the same cryptocurrency across different exchanges. In arbitrage trading, you buy a crypto in one exchange and sell it in another for a higher price. 

Now, you must be wondering how crypto arbitrage is different from traditional arbitrage trading. Traditional arbitrage typically involves buying and selling assets in different physical markets. For example, you might buy a stock on one exchange and sell it immediately on another exchange for a profit. 

On the other hand, cryptocurrency arbitrage involves buying and selling cryptocurrencies on different crypto exchanges

But how is crypto arbitrage trading possible? It is possible because cryptocurrencies are traded on hundreds of different exchanges worldwide round the clock. As a result, there can be significant price discrepancies between different exchanges. 

For example, Bitcoin might be trading at $10,000 on one exchange and $9,800 on another. This can help a trader buy it at $9,800 and sell it at $10,000, making a significant profit of $200. 

To learn how these price discrepancies occur in the first place on different crypto exchanges, you need to study the pricing mechanisms upon which such exchanges work.

Pricing Mechanisms In Crypto Exchanges

To learn more about the process of arbitrage crypto trading, you need to understand the initial pricing mechanism of cryptocurrencies on centralised and decentralised exchanges that majorly contribute to crypto pricing discrepancies across platforms.

Centralised Exchange Pricing (Order Book)

A centralised crypto exchange is a platform where users can buy and sell cryptocurrencies using fiat currencies or other cryptos. The price of a cryptocurrency on such exchanges is determined by a technique known as the ‘order book.’ 

An order book lists all the buy and sell orders for a particular cryptocurrency. The buy orders are listed in descending order of price, and the sell orders are listed in ascending order of price.

The highest buy order and the lowest sell order determine the price of a cryptocurrency. The price will increase if there are more buy orders than sell orders; conversely, the price will decrease if there are more sell orders than buy orders. 

Similarly, the supply and demand for a cryptocurrency also play a role in determining its price. Cryptocurrency prices increase with high demand and low supply and decrease with low demand and high supply.

Decentralised Exchange Pricing (AMMs)

On the other hand, decentralised exchanges use Automated Market Makers (AMMs) to price off their listed cryptocurrencies. An AMM is a liquidity pool that uses algorithms to set asset prices to match buyers and sellers. 

AMMs do not rely on order books, the traditional way that centralised exchanges match buyers and sellers. Instead, they use liquidity pools, which are collections of tokens locked up and used to facilitate trades.

When swapping DEX tokens, you trade with the liquidity pool. The ratio of the two tokens determines the token’s price in a liquidity pool. 

For example, if a liquidity pool contains 100 ETH and 1000 DAI, the price of ETH in DAI would be 10. This is because there are 10 DAI for every 1 ETH in the pool. If you want to buy ETH with DAI, you must deposit DAI into the pool and withdraw ETH. It will increase the demand for ETH and decrease the supply of DAI in the pool, which will cause the price of ETH to increase.

Hence, assets in AMMs are valued based on their internal dynamics instead of conforming to the market, leading to price differences between AMMs and centralised exchanges. This is the gap where crypto arbitrage slips in and helps traders with profitable transactions. 

Now that you have understood the pricing mechanism of centralised and decentralised exchanges, it is time to make you aware of the types of crypto arbitrage trading.

Types Of Crypto Arbitrage

Crypto arbitrage trading strategies come in various forms, each using price discrepancies across different market parts. Let’s explore a couple of these strategies right now.

Triangular Arbitrage

Triangular arbitrage is a trading strategy that uses price discrepancies between three currencies. It involves buying one currency, selling another, and then using a third currency to buy back the first currency, all within a short period. 

The goal is to profit by taking advantage of the fact that the exchange rates between the three currencies do not match.

For Example: 

Let’s say you are a crypto trader, and you notice the following price discrepancies on three different exchanges:

  • Exchange A: BTC/USDT = 30,000 USDT
  • Exchange B: BTC/ETH = 15.2 ETH
  • Exchange C: ETH/USDT = 2,000 USDT

You could exploit this price discrepancy by following these steps:

  1. Buy 1 BTC on Exchange A for 30,000 USDT.
  2. Transfer the 1 BTC to Exchange B and sell it for 15.2 ETH.
  3. Transfer the 15.2 ETH to Exchange C and sell it for 30,400 USDT (15.2 ETH * 2,000 USDT/ETH).

The total profit from this trade would be 400 USDT (30,400 USDT – 30,000 USDT).

Decentralised Arbitrage

However, price differences of a crypto token are not only present between AMMs and centralised exchanges. Some tokens are priced differently in different DEXs as well. 

Decentralised arbitrage utilises price differences between different decentralised cryptocurrency exchanges. It is made possible by the fact that cryptocurrency exchanges are decentralised, meaning any single entity does not control them. This allows arbitrage opportunities to arise when prices on different exchanges are out of sync. 

For Example

Suppose you are a decentralised arbitrage trader and notice that the price of Bitcoin is $10,000 on exchange A but $10,010 on exchange B. This indicates that there is a price difference of $10.

You can now use this price difference by executing a decentralised arbitrage trade. To do this, you would first connect your wallet to a decentralised exchange (DEX). DEXes are exchanges that are not controlled by any central authority.

Once you connect your wallet to a DEX, you place a buy order for Bitcoin on exchange A and a sell order for Bitcoin on exchange B. The DEX would then automatically execute your trades, buying Bitcoin from exchange A and selling it on exchange B.

As a result of these trades, you would now have an extra $10 worth of Bitcoin. It is the profit that you have made from the decentralised arbitrage trade.

Flash Loans for Crypto Arbitrage

Consider a scenario where one exchange, Exchange A, offers an ETH for $200, while another, Exchange B, offers ETH for $205. Applying the crypto arbitrage strategy, you can purchase the token on Exchange A and sell it on Exchange B, resulting in a $5 profit per token.

At first glance, this is a fair gain. However, envision the possibility of investing $200,000 instead. A single transaction could yield a $5,000 profit in such a scenario. The challenge lies in the fact that not all have access to $200,000. This is where flash loans come into play.

Flash loans are a type of loan that allows you to borrow cryptocurrency assets from a decentralised finance (DeFi) platform without any collateral or credit checks. You must return the borrowed amount and interest to the transaction block where you received the loan. 

Such loans implement the use of smart contracts. These contracts are used to automate the flash loan arbitrage process. Your smart contract will typically borrow the cryptocurrency from the first exchange, sell it on the second exchange, and repay the loan in a single transaction. The smart contract will also be programmed to revert the transaction if you cannot repay the loan in full.

Advantages of Flash Loans:

Here are some of the advantages of flash loans: 

  • Access to capital without collateral: Flash loans allow you to access large amounts of money without providing any collateral. It makes them an attractive option for you, with little assets to put up as collateral.
  • Instantaneous transactions: Flash loans are executed instantly, meaning you can access capital and execute trades immediately. This is particularly useful for traders who want to utilise market inefficiencies.
  • Flexibility: Flash loans can execute different financial transactions, such as arbitrage trading, liquidity provision, and yield farming. 
  • Lower fees: Flash loans are typically executed as a single transaction, which can save you on transaction fees. Additionally, some protocols offer flash loan discounts to encourage use.

Risks of Flash Loans

Apart from advantages, flash loans also have some risks which you should consider: 

  • Smart contract risk: Flash loans rely on smart contracts to execute the lending process automatically. If there are any bugs or vulnerabilities in the smart contract, it could lead to significant losses for you.
  • Market volatility risk: The high volatility of cryptocurrencies can lead to significant losses if you fail to repay the loan amount. You must carefully plan and execute your transactions to avoid losses.
  • Reentrancy attacks: Reentrancy attacks are a type of smart contract use that allows attackers to steal funds from a contract multiple times within the transaction. Flash loans can amplify the effects of reentrancy attacks, making them more dangerous.

Let’s know how timing is essential to earn high profits in crypto arbitrage trading.

Timing in Crypto Arbitrage Trading

Timing is of the utmost importance in crypto arbitrage trading because crypto markets are highly volatile, and prices can change rapidly. As you already know, crypto arbitrage can be done by buying a token on one exchange and selling it on another exchange for a higher price. 

Hence, to profit from arbitrage opportunities, traders need to be able to execute their trades quickly and efficiently.

However, arbitrage opportunities are typically short-lived, as traders capitalise quickly. This means that you must be able to execute your trades rapidly to make a profit. This phenomenon is affected by several factors, explained in the following section. 

Factors Affecting Execution Time

Blockchain Transaction Speed

One of the most essential factors is the speed at which a cryptocurrency transaction is processed and confirmed by the blockchain network. It can significantly impact execution time. 

For example, Bitcoin transactions typically take 10-20 minutes to ensure confirmation, while Ethereum transactions can take several minutes or even hours. Bitcoin and Ethereum are proof-of-work blockchains requiring significant computational power to process transactions.

AML Checks by Exchanges

The second factor is the AML checks executed by exchanges. Cryptocurrency exchanges must perform anti-money laundering (AML) checks on all transactions. This process can involve verifying the identity of the sender and recipient and checking for suspicious activity.

These checks can add time to the execution of a cryptocurrency trade. However, they safeguard against money laundering and other financial crimes.

Exchange Server Outages

Exchange server outages can also cause delays in the execution of cryptocurrency trades. This can happen for various reasons, such as power outages, hardware failures, or cyberattacks.

Such server outages are relatively rare, but they can be very disruptive when they do occur. If an exchange server is down, it cannot process any trades until the outage is resolved.

Crypto arbitrage trading is not all glitters; you must also assess the risks explained in the next section. 

Risks and Considerations in Crypto Arbitrage

Along with the glittering profits, the arbitrage crypto strategy also brings in some risk. Enlisted are some of the risks which you must consider before selecting this trading strategy: 

Market Volatility and Sudden Price Movements:

As a crypto arbitrage trader, you need to be aware of the high volatility of the market and the risk of sudden price movements. It could lead to losses if you are not careful. You should use tight stop-loss orders and monitor your trades closely to mitigate this risk.

Blockchain Transaction Speeds and Timing:

Another risk is the blockchain transaction speeds that vary depending on the network. There is a risk that the cryptocurrency price you buy could change significantly before your transaction is confirmed. To mitigate this risk, choose cryptocurrencies with fast transaction times and monitor your trades closely.

Legal Barriers and Geoblocking:

Some countries have regulations or restrictions on cryptocurrency trading. Additionally, some exchanges may only be available to some residents of certain countries. Ensure you know the applicable laws and regulations before you start arbitrage trading.

Platform Fees, Especially on Centralised Exchanges:

Most cryptocurrency exchanges charge fees for trading. These fees can vary depending on the exchange and the type of trade you are making. If you are arbitrage trading, you must pay fees on both the buy and sell trades. Therefore, you must choose a low-fee exchange to maximise your profits.

Importance of Self-Custody and Private Keys

In arbitrage crypto trading, self-custody and private keys hold the utmost importance. They ensure you have complete control over your assets and can make transactions quickly and efficiently. 

But if you are someone who has kept your tokens in the centralised exchange custody, then you must stay aware of the following risks: 

  • Hacks and scams: Centralised exchanges are a prime target for hackers and scammers and have been the subject of numerous high-profile attacks in recent years. Your funds could be stolen or lost if such an exchange is hacked.
  • Exit scams: In an exit scam, the founders of a centralised exchange disappear with all of the customer funds. This has happened several times and is a risk you should be aware of if you consider storing your funds on these exchanges.
  • Regulatory risk: Governments around the world are increasingly scrutinising cryptocurrencies and exchanges. There is a risk that the government can shut down a centralised business, or your funds can be seized.

To overcome these risks, you can always take the path of self-custody. It is the practice of storing your cryptocurrency private keys. This means that you are the only one with access to your funds and are responsible for the security. With the help of self-custody, you can enjoy the following benefits: 

  • Offline storage: When you self-custody your assets, you store your private keys offline on a ledger hardware wallet. These devices use a secure element, a tamper-proof chip designed to protect your private keys. 

Even if someone can physically steal your device, they cannot access your private keys without your PIN code. Moreover, these devices support two-factor authentication (2FA), which adds an extra layer of security to your account. With 2FA, you must enter a code from your mobile phone apart from the PIN code to access your Ledger device. 

  • Greater control: With self-custody, you have complete control over your assets. You can make transactions whenever you want without relying on a third party. 
  • Reduced risk of scams: When you self-custody your assets, you eliminate the risk of falling victim to a centralised exchange scam.

Conclusion

Crypto arbitrage trading can be a lucrative way to profit from the volatile cryptocurrency market, but it is essential to navigate this landscape carefully. To succeed, you must understand the market and act quickly to capitalise on price discrepancies. 

You must also know the risks involved in performing this crypto trading strategy. To mitigate these risks, you should always use a reputable crypto exchange platform and take the necessary steps to secure your funds. 

Trading leads to profit, profits mean taxation, and taxation can be complex. That’s where KoinX comes in. It is a leading crypto tax and portfolio management platform that helps you easily track your crypto investments and calculate your taxes. So join KoinX today and make crypto taxation easier. 

Frequently Asked Questions

How much money do I need to start crypto arbitrage trading?

You can start crypto arbitrage trading with a relatively small amount of money. However, it is essential to note that the more significant your trading capital, the more profits you can make. 

What are the best crypto arbitrage trading bots?

Some popular crypto arbitrage trading bots include Cryptohopper, a cloud-based crypto arbitrage trading bot that offers a variety of features, including automated trading, backtesting, and paper trading. 3Commas is another cloud-based crypto arbitrage trading bot that offers automated trading, portfolio management, and copy trading. Coinigy is a professional-grade crypto arbitrage trading bot that offers automated trading, market analysis, and order management.

How can you improve my crypto arbitrage trading skills?

To improve your crypto arbitrage trading skills, you can:

  • Read books and articles about crypto arbitrage trading.
  • Watch tutorials and videos about crypto arbitrage trading.
  • Practice arbitrage trading on a demo account.

How much money can you make from crypto arbitrage trading?

The amount of money you can make from crypto arbitrage trading varies depending on the market conditions and the crypto arbitrage bot you choose.

Is crypto arbitrage trading legal?

Crypto arbitrage trading is legal in most countries across the globe. However, it is crucial to check the laws in your country before you start trading.

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