What we call Crypto Arbitrage?
Cryptocurrency arbitrage is a specific form of financial arbitrage that capitalises on crypto volatility, liquidity and decentralisation. Arbitrage trading is a strategy that takes advantage of market inefficiencies and price differences across different markets and/or assets. Specifically, it looks carefully at the rates offered by exchanges to find ways to make a profit by quickly trading in a loop.
Different exchanges will have different numbers of buyers and sellers, different trading preferences and different specialisms. This helps ensure that some inconsistencies occur between spot rates for different markets or instruments, such as Bitcoin.
How Does Arbitrage Work?
The concept of arbitrage is very simple. The arbitrageur can earn a risk-free profit by taking advantage of the price difference between equivalent assets, buying low and selling high.
For example, suppose you buy avocados from a farmer for $1.00 each. You then sell the avocados to a local restaurant for $1.50 a piece. In this case, you earn 50 cents for every avocado you sell.
Financial arbitrage is similar, but the price of a financial asset can change instantly. In order to take advantage of the price differentials of an asset like a stock, you need to trade at the same time so that the price does not change during the trade.
What Does an Arbitrageur Do?
Arbitrageurs use trading strategies designed to profit from slight differences in the prices of comparable assets. The support can be stocks, bonds, currencies, commodities, or other financial instruments that can be traded. Deficiencies in the financial markets, such as delays in stock price updates, can present excellent opportunities for arbitrageurs.
To engage in arbitrage, an investor buys a stock on one exchange and simultaneously sells the same stock on another exchange. If the transactions take place at the same time, there is no possibility of the stock price fluctuating during the trade. By trading the same stock at a higher price, the arbitrageur earns a risk-free profit equal to the difference between the assets at different prices.
Due to price differentials and time constraints, arbitrage trading is mainly conducted by institutional investors, such as hedge funds and banks. Arbitrage trading is difficult for many retail investors who trade stocks on smartphones because of the significant technical resources required to trade between various stock exchanges simultaneously.
In addition, the price difference between two financial assets can be minute. To take advantage of the slight price difference to arbitrage and make a profit requires a large amount of capital.
Arbitrage Example
Let's look at a two-currency arbitrage: bank A buys one pound at $1.2500 and sells it at $1.2700. On the other hand, Bank B buys the same pound at $1.2700 and sells it at $1.2900.
In this case, a trader looking to profit from the price difference between the two banks would utilize a two-currency arbitrage trading strategy.
Similarly, a trader could use $100,000 to buy British pounds from Bank A and immediately sell the same to Bank B. In this case, the trader would earn a profit of $1,000.
Arbitrage Trading Advantages
By exploiting market inefficiencies, arbitrageurs help the financial system by ensuring that prices are equalized through a supply and demand system. When an arbitrageur buys an asset from a cheaper market and sells the same asset in a more expensive market, demand for the asset in the cheaper market increases, causing prices to rise. On the other hand, supply increases in the more expensive market, causing prices to fall.
With sufficient arbitrage, asset prices between the two markets will equalize, and overall efficiency will be maximized. The equalization of market prices without the possibility of arbitrage is called arbitrage equilibrium.
Low-Risk profit
Arbitrage trading is a very low-risk way to profit because buying and selling are done simultaneously to take advantage of price fluctuations. Trades are triggered with the intention of posting a certain amount of profit by trading a large number of shares. Other traders taking advantage of the same arbitrage opportunity may move the price up or down unfavorably. Therefore, time is of the essence in arbitrage trading, which is executed and managed by the hedge fund manager or financial institution where you can invest.