1. What is Arbitrage
Introduction
You’ve probably heard of arbitrage before. Sometimes shortened to ARB, it involves the purchase and sale of identical assets at the same time. This gives traders the chance to profit from a mismatch in their prices, which is what everyone dreams of, right?
This type of trade earns profits by taking advantage of market inefficiencies. So when there’s a price difference between equivalent financial securities in different markets, that’s your time to pounce. In the simplest terms possible, arbitrage involves making a risk-free profit from pricing discrepancies.
Arbitrage may sound easy, but finding the right arbitrage opportunity and executing it proficiently can be quite a challenge. That being said, there are huge benefits to the strategy, such as the low or non-existent risk on the trades.
Arbitrage can be conducted on any asset which trades for differing amounts on at least two exchanges. It can be done with financial securities, foreign exchange, gold and other metals, short term interest rates, commodities, and even cryptocurrencies. Where there are multiple markets trading in the same assets, there will be arbitrage opportunities.
Example
Maybe it would be easier if we just gave an example. Say there’s a stockbroker in New York who notices that the stock of your favorite blue-chip company is trading for $1 less on the London Stock Exchange than on the Tokyo Stock Exchange.
As soon as he sees this, he seizes the opportunity and buys 100 units on the LSE while instantaneously selling the same number on the TYO.
This transaction nets him $100 almost instantly, risk-free. Jumping on arbitrage opportunities as they arise and having large amounts of capital to execute on these trades is the key to profiting with this strategy.
That’s a fairly simple example, but arbitrage plays can get much more complicated. In a now-famous example that was kept secret for years, Spread Networks spent billions of dollars connecting the Chicago Mercantile Exchange with the New York Stock exchange via fiber optic cable.
Why did they do this?
All these billions were just so they could make an arbitrage by having a technological advantage over the competition. Even with a speed that is a fraction of a millisecond better than other traders, they had better data and could beat the competition. Pretty crazy, huh?
As a side note: the Spread Network maneuver is today famous in popular culture through the book Flash Boys by Michael Lewis, in case you want to learn more.
This is an extreme example, but it shows how lucrative arbitrage can be. After all, if billions were spent by Spread Networks just on the infrastructure, imagine how much money they intended to make off of arbitrage!
Why arbitrage trade?
So why should you implement an arbitrage strategy? Well the number one benefit of ARB plays is the lack of risk. Now, this does not mean that this strategy is risk-free. What it does mean is that there is less inherent risk in performing arbitrage than there is in holding an asset in the long run.
This is because arbitrage is done quickly and your cash is only exposed to market forces for the blink of a second it takes to complete your transaction. Another benefit is that the money made in successful arbitrage deals is guaranteed as long as the plan is executed properly.
So in simple terms: ARB plays are risk-free if you act on them as soon as you see the discrepancy.
Two Ways to Succeed
There are 2 main ways to succeed with arbitrage:
- Processing a large number of transactions
- Processing fewer transactions which are larger (this requires lots of capital)
The difference in prices that ARB takes advantage of can be minuscule and you really need to have scale to fully capitalize on these types of opportunities.
So you either have to find a lot of them (something which a trading bot can help you do) and make a small amount of money on each, or find a few big opportunities and go all-in on them to win big.
2. Arbitrage with Public Equities
We mentioned an example earlier where a stockbroker profited by spotting a difference in the stock price of a blue-chip company between the London and Tokyo exchanges. That’s just one of many varying types of ARB you can capitalize on. Here are a few more arbitrage strategies you might appreciate:
Risk Arbitrage
As a favorite among hedge funds, risk arbitrage is often referred to as merger arbitrage. If you want to pull this off, there needs to be a merger between two large publicly traded corporations. The strategy is to find a company that is being acquired and purchase their stock, while selling short the stock of the company making the acquisition.
The hope in this trade is that the acquisition increases in value as the acquiring company sheds value.
If this occurs, then the trader has made a handy profit. The market generally pushes the purchaser and acquirer’s stocks in this way, so you’ll see. Learning early about a merger can pay off big in risk arbitrage, however this is much easier said than done.
Convertible Arbitrage
The convertible arbitrage strategy is a longer-term play and is a way of holding a security while also hedging. It is a play favoured by hedge funds and large “whale” traders. It involves purchasing a position (aka “going long”) in a convertible security and also buying an accompanying short position in the underlying common stock.
This strategy takes advantage of price inefficiencies between the convertible security and its underlying stock. This is when you can jump in and capitalize on pricing mismatches between the convertible and the stock.
There is some smart thinking behind the convertible ARB strategy. It’s pretty simple and allows you to make gains while taking less risk.
For example, if a stock declines, the trader will gain from his or her short position in the stock. Meanwhile, the convertible bond or debenture has less of a downside risk due to the fact that it is a fixed-income financial instrument. And if the stock does go up in price, the loss on the short gets offset by the gains on the convertible instrument. Finally, if no movement occurs the convertible pays a coupon that may even offset the costs of holding the short position.
Seems like a pretty good deal, right?
Arbitrage Applies Everywhere: Retail Arbitrage
The strategy of arbitrage goes beyond finance and can apply to any market anywhere. Some people have found success (believe it or not) in retail arbitrage.
These “businesspeople” purchase items in retail stores and then sell them for more online. I think we all have a friend like this…
The strategy works, and some people make a killing doing it. It is capital intensive, as all items must be purchased upfront before selling, but can generate good returns on the right items (like limited edition sneakers).
Triangular Arbitrage
Triangular arbitrage (also known as cross-currency arbitrage and three-point arbitrage) involves making a riskless profit by taking advantage of pricing discrepancies between three different currencies, in the forex market or elsewhere. Each point in a triangle would then represent a currency.
Triangular ARB strategies involve three trades: exchanging one currency for a second, the second currency for a third currency and then finally trading the third currency back for the starting one.
The really cool part is that once the second trade happens, the trader has locked in a zero-risk profit. For this process to work, a quoted market exchange rate needs to be different from the market’s cross exchange rate.
Triangular arbitrage opportunities are rare and traders who are smart enough to take advantage of them usually automate the process of their discovery with advanced computer hardware. Before you get too excited, this type of strategy only works when transaction costs are low.
Price differentiation between exchange rates can be mere fractions of a penny. So for cross-currency arbitrage to work and generate a profit, an arbitrageur must trade with a lot of capital.
Statistical Arbitrage
Our last type of arbitrage is statistical arbitrage. This method is heavy on the quantitative side and requires an analytical approach to trading. The main theme behind statistical arbitrage is to use mean-reversion models to invest in broadly diversified security portfolios, each containing hundreds to thousands of different securities. It involves short-term financing with time periods to enter and close out trades of a few seconds up to a couple of days. If that didn’t make sense to you, that’s fine. There is lower-hanging fruit for you to profit from.
This type of strategy is generally supported by computational and mathematical trading platforms. Statistical arbitrage is market neutral because it involves opening a long and short position at the same time in order to capitalize on inefficient pricing in correlated securities.
However, this type of arbitrage is not without its risks. For the strategy to succeed, it needs to rely on market prices returning to historical (and therefore predicted) averages, something that doesn’t always happen. Therefore, statistical arbitrage is not as low-risk as other types of arbitrage.
3. How Arbitrage Works Differently with Crypto
So does arbitrage work with cryptos?
Of course it does! In fact, Kit Trading, part of Singaporean Hedge Fund Vulpes Investment Management, is in the process of raising $10 million USD for a dedicated crypto arbitrage fund.
The crypto space is a developing market with tons of opportunities for arbitrage plays. Many companies are looking to capitalize on the volatile cryptocurrency markets and imbalances in liquidity that exist between different exchanges of different sizes.
This is why we have seen so many traders flock to cryptocurrency trading recently. However, with the emergence of high-frequency trading and other technologies, there are going to be fewer completely risk-free arbitrage opportunities.
The same methods that allow a multi-million dollar hedge fund to arbitrage the crypto markets are available to you too. In fact, it’s much more of an even playing field because the big banks aren’t as established in this area yet, and many of them don’t even have crypto trading desks. This is where opportunity is born for the average trader.
However, price discrepancies can be miniscule and it takes a lot of capital or very frequent trades to generate profits. Using leverage is one of the best ways to increase your profits and make a high return on crypto arbitrage. The good news is that many cryptocurrency exchanges allow for a ton of arbitrage, mostly because of the unregulated nature of this sector.
The world of crypto is fast-paced and when living in such a volatile environment it pays to be lightning fast. Technology like trading bots can help give traders an edge over other traders who are executing manually. They can also be set up to work while you are sleeping, through the use of crypto ARB bots.
4. Crypto Arbitrage Strategies
First, let’s lay out a basic crypto arbitrage strategy in which the arbitrageur aims to take advantage of price discrepancies of the same asset in different markets.
In this case, the trader finds a price mismatch between the same token on two different exchanges. He or she buys the token from the exchange that it is trading lower on. He then sells it on the exchange the crypto is selling for higher on.
By taking advantage of the price discrepancy the trader pockets a riskless profit. This strategy is relatively straightforward and does not require any additional trades beyond those required to swap the two cryptocurrencies.
Second, we should lay out a slightly more complicated but worthwhile and profitable strategy with crypto: triangular arbitrage. We have already outlined the basics of triangular arbitrage above; applying it to crypto is pretty straightforward.
Triangular arbitrage of crypto assets involves studying the exchange rates between three different crypto assets to find discrepancies which the arbitrageur can profit from, just like with any other asset.
Example
One example of triangular arbitrage would be if you found a discrepancy in prices between BTC, ETH, and BNB. Numbers will obviously change over time, but for the purposes of this example, we’ll say that the BTC/BNB rate is 462.963, the BTC/ETH rate is 48.9809, the ETH/USDT rate is 148.94, and the BNB/USDT rate is 15.37. USDT is necessary to use as an intermediary since there is no BNB/ETH currency pairing in this example. Like in all triangular arbitrage strategies, once the second of the three trades is locked in the trader has secured a riskless profit.
So say you see that there is a price inefficiency when you put all these rates into Excel. What you would do is sell your BTC to ETH (1 BTC = 48.809 ETH), convert that ETH into USDT and then BNB (48.809 ETH = 472.9747 BNB), and then convert that BNB back to BTC (472.9747 BNB = 1.0216 BTC). Therefore, you have profited 2.52% nearly instantly!
Finally, you should understand convergence arbitrage. This strategy is to purchase a coin on an exchange it is undervalued on and simultaneously, on an exchange where the coin is overvalued, shorting the same coin. The idea is that the prices will slowly move towards each other (or “converge” – hence the name) and meet at a point in the middle. As this occurs, the trade will yield a profit.
Setting up a crypto arbitrage strategy
Now that you know some of the possible ways to make money arbitrage trading with cryptocurrency, let’s discuss how you can earn some risk-free returns on Binance. The reason why we recommend this exchange is because of its wide selection of coin pairings and its Coin Aggregator function that shows these pairings. Without these pairings, it becomes too complex to make a profit and keep the risk low.
Step 1: Set up a comparison chart between the same coin on two different exchanges.
Step 2: Watch patiently (or set an alert) for when there is a pricing mismatch. There are also a number of tools you can use for this purpose.
Step 3: When a wide enough inefficiency is present, buy the token on the lower priced exchange and sell it on the higher priced one. Binance makes this very easy to do, and has lots of tutorials for how to use their trading functionalities.
Step 4: If the difference in prices persists, consider setting up a bot (this will be discussed in our next article).
5. Risks of Crypto Arbitrage
You might find the idea of risk-free profit alluring. There are however drawbacks, risks, and other difficulties of engaging in crypto ARB. For one, Know Your Customer (KYC) and Anti Money Laundering regulations are now widespread among exchanges.
Depending on what jurisdiction you’re in or exchange you use, you may require some form of collection and verification of customer identification. This may include government-issued ID, phone number, physical address, email address, or even utility bill.
And as you know, exchanges can put withdrawal controls on accounts that look sketchy to them. Some exchanges screen withdrawal requests for suspicious transaction volume and velocity in order to prevent fraud. So beware, lest this friction cut into your arbitrage profits.
Your security isn’t assured either. Since the beginning of crypto exchanges, there have been hacks where entire exchanges go down or suffer catastrophically large thefts. There is always a chance that the exchange you’re using will be the next Mt. Gox. But hopefully not.
When performing crypto arbitrage a trader needs to use multiple exchanges and take advantage of price discrepancies no matter where they are. This exposes the trader to more exchanges and more obscure, smaller volume exchanges. These may not have superb security systems and are more vulnerable to attack. It is always best practice to move all crypto to the most secure exchange after making arbitrage plays.
Another drawback to crypto arbitrage (and any other form of crypto trading that involves exchanges) is the withdrawal fees. Right now, the market is fairly undeveloped and exchanges can get away with charging high withdrawal fees. These can really cut into profits. We advise you to have a strategy in place that minimizes withdrawal fees in a systematized way so you can maximize your crypto arbitrage profits.
Withdrawal Issues
Another risk with crypto arbitrage is that there might be problems with withdrawing purchased assets from the exchange you have purchased such assets from. For example, a user on Bitcointalk.org (Darooghe) mentioned trying to take advantage of arbitrage opportunities by buying cheap Icon coin on HitBTC only to find out that he/she could not withdraw it and sell on a different exchange. This is also a potential problem you must be aware of before engaging in crypto arbitrage trading.
6. Conclusion
Now that we’ve gone through all the ways you can execute arbitrage strategies in public equity markets, as well as the more untapped cryptocurrency exchanges, it’s time to get started!
You’ve got several strategies at your disposal. As long as you can find a good exchange for capitalizing on these arbitrage opportunities, you will be able to earn solid low-risk returns.
One exchange we have found to be good for arbitrage that minimizes many of the risks mentioned above is Binance. The coin aggregator function gives you access to more than 1,500 coins. This means that you’ll be able to investigate triangular arbitrage opportunities over tons of exchanges and coins. This should be more than enough for you to get started. Good luck!
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About the author: This article is written by Will Bartlett. Will has three years of experience writing and marketing in the crypto and blockchain space. Other areas of expertise include real estate, investing, and business strategy.
Sources:
https://www.fool.com/knowledge-center/what-is-arbitrage.aspx
https://www.investopedia.com/terms/a/arbitrage.asp
https://www.quora.com/What-are-the-different-arbitrage-strategies-that-are-used
