Despite the overwhelming popularity of cryptocurrencies and digital assets, the crypto market is still very volatile. This volatility is one of the core reasons investors fear engaging in the crypto market.
Nonetheless, both beginner and experienced crypto traders can make short-term gains in several ways with little risk. One strategy is called arbitrage trading. This trading strategy is popular among investors with a low-risk tolerance, but it still has its fair share of drawbacks.
This guide will explain what cryptocurrency arbitrage trading is, different strategy types, and the pros and cons you should consider.
What Is Arbitrage Trading in Crypto?
Arbitrage trading refers to the simultaneous purchase and sale of a crypto asset on multiple markets to exploit different price points. Generally speaking, arbitrage works by buying a cryptocurrency on one market and selling it on a different market with a higher selling point.
The key is finding a marginal difference for a crypto asset on different exchanges and over-the-counter (OTC) trading platforms. Since the crypto market is often volatile, prices can fluctuate constantly during the day.
Arbitrage traders are vigilant in finding varying crypto prices and making rapid-fire transactions. In doing so, they incur almost no risk. However, their profits are usually small because differences in cryptocurrency values are typically minimal.
To illustrate this concept: When someone buys $12 worth of Bitcoin (BTC) on one platform and sells it for $13 on another, they’ve just engaged in arbitrage trading.
Arbitrage trading is ultimately a trading strategy that takes advantage of the inefficiencies of the crypto market.
Types of Crypto Arbitrage Strategies
Crypto arbitrage trading involves a wide array of different strategies, including:
Cross-Exchange Arbitrage
Cross-exchange arbitrage refers to exploiting price differences between different cryptocurrency exchanges. Crypto market prices tend to vary tremendously across different crypto exchanges. Therefore, arbitrage traders can use multiple crypto exchanges to find profit margins and make quick transactions.
For example, a crypto trader will create an account on popular exchanges like Coinbase and Kraken. Then, they’ll closely monitor the order book to find discrepancies between prices on each platform. When they find one, the trader will buy on one platform and sell on another.
Cross-exchange arbitrage trading is the most common strategy for crypto investors to make quick gains without much effort.
Spatial Arbitrage
Spatial arbitrage involves exploiting the price differences of a crypto asset in different geographical locations. For example, a cryptocurrency in one country may be cheaper or more expensive in another.
Spatial arbitrage traders typically buy low in a cheaper area and sell high in an expensive region. This strategy offers an enormous opportunity to profit substantially in the crypto market.
However, there are certain logistical challenges to overcome. Sudden regulatory changes and geopolitical uncertainty can quickly decrease expected arbitrage earnings.
Triangular Arbitrage
Triangular arbitrage is a complicated trading strategy that exploits the price discrepancies of three different assets within the same exchange. An example would be a trader buying a cheaper currency, converting it to a more expensive currency, and making a sale.
Triangular arbitrage can be effective at times when the right price differences overlap. However, it’s a difficult strategy to scale and maintain.
To succeed, you’ll need to monitor three different cryptocurrencies in the same market closely. On top of that, you’ll have to quickly analyze and determine the right crypto combinations in order to make a profit.
Time Arbitrage
Time arbitrage entails taking advantage of the delay in price updates across different platforms. While famous investors like Warren Buffet and Peter Lynch have used time arbitrage for their gain, it’s not a widely used tactic in the digital asset space because of the constant volatility in the crypto market.
Ultimately, time arbitrage takes advantage of short-term price changes that will disappear in the long-term crypto market. One popular time arbitrage strategy is to purchase cryptocurrencies when prices temporarily decrease due to market fluctuations, with the hope that they’ll rebound in time.
Another time arbitrage strategy is to buy or sell cryptocurrencies at the exact moment a news development affects the crypto market. To succeed in time arbitrage, a trader needs powerful tools to monitor crypto markets and global finance news in real time.
Pros of Arbitrage Trading
Arbitrage trading is a legitimate investing strategy in the crypto market. Here are the advantages of getting started as an arbitrage trader.
Potential for Risk-Free Profits
Exploiting price discrepancies across markets allows arbitrageurs to secure profits without any inherent risk to their capital. They essentially buy low and sell high, locking in the difference. Under the right conditions, low-risk investors can use the volatility of the crypto market to their advantage and make long-term profits.
Diversification
Diversification is a tried-and-true investment strategy for spreading investments into different asset classes. Diversifying across different markets and assets can inherently manage risk across investments. Arbitrage trading often involves multiple movements through simultaneous positions, offering some level of diversification.
Granted, arbitrage trading isn’t a definite diversification strategy. Still, traders can achieve similar results by keeping their investments in different cryptocurrencies, especially using the triangular arbitrage method.
Short-Term Holding Periods
The holding period for each asset in arbitrage plays can be very short, minimizing exposure to market fluctuations and reducing capital lock-up. Engaging in arbitrage trading is essentially playing the short game. Traders can keep their capital moving quickly to reduce risk and improve the liquidity of their assets.
Low Transaction Costs
With efficient execution and optimized trading strategies, traders can minimize transaction fees, which can maximize profit potential. While exchange fees can decrease potential arbitrage gains, there are few transaction costs involved for trading across different decentralized exchanges and currencies.
Cons of Arbitrage Trading
Arbitrage trading is far from a perfect trading strategy. Before you begin, it’s essential to take into account these drawbacks to arbitrage trading.
Limited Profit Potential
Profit margins in arbitrage are typically small, requiring high trading volume to generate significant returns. This can lead to high transaction costs, negating potential profits at times. As such, arbitrage trading is a low-risk, low-reward trading strategy.
The consequence of low margins is multiplied by the fact that successful arbitrage is often difficult. You have to meet all the right conditions to gain a low profit. If one puzzle piece falls out of place, your hard work and effort will be wasted.
If you’re driven to make high profits, you may want to consider implementing a moderate to high-risk trading strategy instead of arbitrage.
Speed and Efficiency Are Crucial
The success of arbitrage trading hinges on executing trades quickly and efficiently before price discrepancies disappear. This demands technical expertise, powerful tools, and fast market access — all of which may not be available to beginner traders.
Without fast market access, traders risk missing out on split-second price differences. The absence of arbitrage tools makes it difficult to scale any efficient trading profit to make long-term gains.
Even with both technologies at their disposal, beginner traders can fall behind the competition if they don’t have prior arbitrage experience. To succeed at arbitrage, a trader must have a balanced mix of expertise, trading resources, and quick access to crypto markets, which isn’t a simple balance to achieve.
Fierce Competition
Many experienced traders compete for the same arbitrage opportunities, making it increasingly challenging to find profitable discrepancies. Because arbitrage is a low-risk strategy, millions of traders across the world use it.
With this high degree of competition, price discrepancies can be difficult to come by. As such, successful arbitrage trading requires continuous monitoring and adaptation.
In addition, cryptocurrency markets are constantly evolving. This means that traders must stay on top of new developments and technology that can impact global crypto markets.
Technical Complexity
Arbitrage trading isn’t a simple investment strategy. It requires advanced strategies and tools, creating a barrier to entry for less experienced traders. In addition, arbitrage trading is highly competitive.
Successful traders have to be innovative in experimenting with diverse strategies to maximize their profits. Beginner traders typically have to undergo a massive learning curve to understand the market.
New arbitrageurs can earn little to no profit during this time, until they can adjust and build winning strategies. The silver lining is that all meaningful investment strategies have a steep learning curve, as there are no foolproof ways to profit on the crypto market.
AlphaPoint Is Your Trusted Partner in the World of Crypto Arbitrage
Arbitrage trading offers a straightforward method for generating small but quick gains in the crypto market. While it involves a steep learning curve and fierce competition, skilled arbitrageurs can generate steady income with minimal risk.
Financial institutions can take advantage of the popularity of arbitrage trading by embracing digital asset management. AlphaPoint’s white-label software makes it simple for financial institutions to create a profitable crypto exchange. We also provide crypto liquidity partner integration to keep your exchange running smoothly.
Request a demo today to learn more about how our software can work for you.
