What is Cryptocurrency Arbitrage?
Cryptocurrency arbitrage is a strategy in which investors buy a cryptocurrency on one exchange and then quickly sell it on another exchange for a higher price.
Cryptocurrencies like Bitcoin trade on hundreds of different exchanges, and sometimes, the price of a coin or token may differ on one exchange versus another. That’s where the classic Wall Street strategy of “arbitrage” comes in. “Capturing the arb” means taking advantage of the fact that an asset is selling for cheap in one place and at a higher price in another market.
With crypto arbitrage therefore, investors seize upon the opportunity that a digital currency is trading at a lower price on one exchange by buying and selling it almost immediately for a higher price on another exchange. Here’s a closer look at how crypto arbitrage works and trading strategies that use the tactic.
What Types of Arbitrage Exist?
There are some different ways investors can conduct crypto arbitrage. These are a couple of the types.
Spatial arbitrage involves trading virtual currencies across two different exchange platforms. Spatial arbitrage is a straightforward way of conducting crypto arbitrage.
While this is a simple tactic that can take advantage of price discrepancies, spatial arbitrage exposes the traders to risks like transfer times and costs.
Spatial Arbitrage Without Transferring
Some traders try to to avoid the risks of transfer costs and times that spatial arbitrage poses. For example, in a hypothetical case, they may go long Bitcoin on one exchange and short on another and wait until the prices on the two exchanges converge.
That allows them to avoid transferring coins and tokens from one platform to another. However, trading fees may still apply.
Triangular arbitrage takes advantage of pricing inefficiencies among different pairs of cryptocurrencies on the same exchange. With this strategy, an investor starts with one cryptocurrency and then trades it for another cryptocurrency on that same exchange—one which is undervalued relative to the first crypto.
The investor would then trade that second cryptocurrency for a third cryptocurrency which is relatively overvalued when compared with the first. Finally, the investor would trade that third cryptocurrency for the first crypto, completing the circuit a little richer.
How to Take Advantage of Crypto Arbitrage Algorithmically
At first glance, cryptocurrency arbitrage seems like a simple matter of looking for gaps between the prices on one exchange and another, and then executing a buy and a sell.
Famously, in 2017 there was a moment when the price of Bitcoin on Kraken was $17,212, but only $16,979 on Bitstamp—presenting an arbitrage opportunity. In that instance, an investor could potentially make $233 per Bitcoin by buying them on Bitstamp, and then quickly selling them on Kraken.
While Bitcoin spreads aren’t always as wide as in the above example, there are times when other, less well-known forms of crypto could offer even wider gaps. Since cryptocurrency prices can vary from exchange to exchange, arbitrage opportunities can pop up, with thousands of cryptocurrencies trading on hundreds of exchanges for people investing in cryptocurrency.
There are a number of apps investors can download that will track the prices of Bitcoin and other cryptocurrencies for arbitrage opportunities. This way, investors can take advantage of algorithms that automatically scan for arbitrage across different crypto exchanges. This automated approach can allow crypto-arbitrage traders to take advantage of multiple different price discrepancies.
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How to Find a Crypto Arbitrage
Not every cryptocurrency digital asset is created equal when it comes to arbitrage.
For instance, Bitcoin has become very widely traded. That’s resulted in fewer Bitcoin arbitrage opportunities.
But there are other ways to get involved in crypto arbitrage besides investing in bitcoin.
Method 1: New Software
With so many different cryptocurrencies on so many exchanges, finding those opportunities is a daunting task. That’s why many traders use software applications that track the hundreds of cryptocurrency exchanges in real time.
There are a growing number of companies that specialize in software to automate crypto arbitrage. Some companies have a tool that allows investors to choose an automated arbitrage strategy and execute it across different exchanges.
Method 2: Less Popular Cryptocurrencies
Investors can find bigger price spreads for the same cryptocurrency digital assets among less-popular, less-frequently traded forms of crypto.
Because they’re less popular, though, these cryptocurrencies are prone to rapid price fluctuations. That volatility can be good or bad news, but it adds another level of risk to an arbitrage strategy.
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What Are the Dangers of Crypto Arbitrage?
To succeed in crypto arbitrage, investors need to execute the trades quickly in order to take advantage of cryptocurrency price differences from exchange to exchange, while those differences are still profitable.
With the thinly traded forms of crypto that offer the widest spreads, a trader has to be careful not to increase the purchase price and decrease the sale price of a digital asset by their own trades.
The crypto exchanges all work similarly, pricing crypto based on the last trade on that exchange. But it’s important to note that not all exchanges are created equal. Some of them have enormous trading volumes, while others aren’t as active. The trading volume on each affects the liquidity and the available prices on a given exchange.
Low volume may mean that the exchange can’t execute a trade large enough to deliver the profit an investor is hoping for. Low volume may also mean that the trade is possible but will take too long to seize the pricing opportunity.
At the same time, traders need to keep an eye on the transaction fees that come with purchasing cryptocurrency across trading platforms. As the cryptocurrency markets evolve, these fees continue to fluctuate, varying from exchange to exchange.
Cryptocurrencies are largely unregulated, which is one of the key things to know before investing in cryptocurrency.
As a result, they come with more risks from hacks, fraud, and outright currency collapse. That’s why securely storing your cryptocurrencies is a hot topic among investors.
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In the US, where cryptocurrency adoption has skyrocketed in recent years, the IRS has created a tax guide which categorizes cryptocurrencies as property. The Securities and Exchange Commission, on the other hand, has called cryptocurrencies a form of security—and the Commodity Futures Trading Commission has called them a form of commodity.
Recommended: Is Crypto a Commodity or a Security?
The IRS treats cryptocurrency gains in the same way as gains made from selling property. With that in mind, investors must account for any capital gains taxes on their Federal income tax return, but may also be able to take deductions based on any losses.
Arbitrage exists across the capital markets, in stocks, bonds and commodities, wherever the same asset trades for different prices in different places. Since cryptocurrencies are digital and aren’t based on an underlying asset, it is harder to place a value upon and doesn’t have the same pricing conventions as equities and bonds, which are tied to the performance of a company, municipality or nation.
Cryptocurrency is complicated, and arbitrage strategies can be even more complex. But the practice is legal, and has the potential to yield high rewards while also exposing an investor to high risk.
As with any investment strategy, it is important for investors to do their own research when exploring crypto arbitrage, including looking at different, lesser-known cryptocurrencies, and available software to track cryptocurrency exchanges in real time.
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