Arbitrage Trading – a Reality Check

Arbitrage trading has taken off in recent years on the cryptocurrency market. Of course, the concept of arbitrage trading has always existed in finance. Simply put, arbitrage involves taking advantage of price differences that are inherent in financial markets. In a perfect market – in an efficient market – the same asset would be trading at the same price everywhere. As financial markets can be inefficient and are certainly imperfect, situations arise when the same financial asset is simultaneously trading at different prices on various platforms.

As a decentralized place with a large number of exchanges, the cryptocurrency market can be inefficient. It takes time for prices to converge and catch up with the market. This leads to price differences that can be exploited by a quick arbitrage trader. Suppose that Bitcoin (BTC) is trading at $8,500 on Kraken, but at $8,900 on Huobi. An arbitrage trader could buy one BTC on Kraken and transfer it to Huobi for subsequent sale at $8,900, for a gross profit of $400. It is also possible to perform arbitrage between different cryptocurrencies. 1 BTC might be worth 45 Ethereum (ETH) on Bittrex and 47 ETH on Kraken. An arbitrage trader can buy 1 BTC for 45 ETH on Bittrex and transfer the BTC to Kraken, where the BTC will be sold in exchange for 47 ETH, for a gross profit of 2 ETC.

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The question is whether arbitrage trading is actually worth it. A popular misconception holds that arbitrage trading is a good way to make money quickly with little risk. This is not true. Cryptocurrency arbitrage is certainly not risk-free. In fact, cryptocurrency arbitrage might not be a viable trading strategy in the long term. This is for several reasons.

You might have noted that the profit in the above examples is gross – that is, this profit excludes the commission fees that you have to pay on your trades. But you should never exclude commissions from your profit calculations. There are typically commission fees for buy and sell orders as well as for transfers between exchanges. These fees add up and eat away at profits. It’s not enough to identify a profitable arbitrage opportunity; the spread between the prices has to take into account all the commission fees that you will incur on the trade. Failure to make an allowance for the commission fees can result in a loss.

Another problem is the time that it takes to transfer crypto coins between exchanges. The time that it takes for a transfer to be completed might be long – certainly long enough for the market to turn against you. Cryptocurrencies can be volatile and, by the time your arbitrage operation is complete, you might well end up in the red if prices have moved against you. The market usually corrects price discrepancies, and an arbitrage opportunity that you identified might be corrected before you have a chance to make money off it.

Finally, as more arbitrage traders move in and the cryptocurrency market becomes more mature in general, arbitrage opportunities are bound to become fewer in number.

Some arbitrage traders choose to maintain cryptocurrency and fiat reserves on several exchanges as they wait for arbitrage opportunities. This tactic helps arbitrage traders avoid crypto asset transfers between exchanges. However, this may not be practical for the average arbitrage trader, who might not have the financial wherewithal needed to maintain reserves on several exchanges. Also, the trader is limited to certain exchanges in this situation, therefore losing some of the flexibility enjoyed by arbitrage traders pursuing a more conventional strategy.

As you can see, cryptocurrency arbitrage involves risks and is certainly not an easy way to make money. This does not mean that cryptocurrency arbitrage is always a bad idea. For the right type of trader, this can be a workable strategy. Arbitrage traders who have the right tools, and are aware of all the risks and commission fees, can perform arbitrage trading effectively, particularly if they take the time to analyze market depth. Market depth often reveals arbitrage situations that wouldn’t otherwise be visible. Either way, do your homework and tread carefully.

Boris Fesenko

BJF Trading Group Inc., Oakville, ON, Canada

Disclosure: This is a sponsored article