Cryptocurrencies have the potential to revolutionize the modern world. Cryptocurrency trading is a lucrative business, but there are challenges as well. Arbitrage trading is a relatively low-risk trading strategy that takes advantage of price differences across markets. Most of the time, this involves buying and selling the same asset as Bitcoin on different exchanges.
Interestingly, this is a very common strategy in the trading world, but it’s mostly been a tool of large financial institutions. However, with the democratization of financial markets thanks to cryptocurrencies, arbitrage trading might be useful for cryptocurrency traders as well.
Importantly, there is no such thing as a guaranteed profit. However, arbitrage trading is one of the best if not the best option. People should keep in mind that traders compete ferociously to get the opportunity to enter these types of markets. Nevertheless, for this very reason, profits are generally slim in arbitrage trading and depend heavily on speed and volume per trade. As a reminder, that is why most arbitrage trading is done by algorithms developed by high-frequency trading firms.
It is worth noting that arbitrage trading is a trading strategy that aims to generate profit by simultaneously buying an asset in a market and selling it in another market. Notably, this is most commonly done between identical assets traded on different exchanges. Importantly, the difference in price between these financial instruments, will in theory be zero since they are quite literally the same asset.
There are certain challenges as well. Importantly, the challenge an arbitrage trader has is not only finding these pricing differences but also being able to trade them in a short period of time. People who lack experience should keep in mind that since other arbitrage traders are likely to see this difference in price as well, the window of opportunity usually closes in no time at all.
Moreover, since arbitrage trades are generally low-risk, the returns are generally low. As a result, arbitrage traders not only need to act quickly, but they need a lot of capital to use this strategy effectively.
Most common types of arbitrage trading
Let’s have a look at various types of arbitrage trading. It is no secret that there are many types of arbitrage strategies all over the world. However, there are some distinct types that are quite commonly used.
Importantly, the most common type of arbitrage trading is the exchange arbitrage. A trader buys the same crypto asset in one exchange and sells it on another. It is worth noting that the price of cryptocurrencies can change quickly, and people should be aware of this fact.
This is not the end of the story as there are other common types as well. For instance, another common type of trading for crypto derivatives traders is funding rate arbitrage. Interestingly, when a trader buys a cryptocurrency and hedges its price movement with a futures contract in the same cryptocurrency that has a funding rate lower than the cost of purchasing the cryptocurrency.
Another very common type of arbitrage trading in the cryptocurrency world is triangular arbitrage. Notably, this type of arbitrage is when a trader notices a price discrepancy between three different cryptocurrencies and exchanges them for one another in a kind of loop.
Importantly, while arbitrage trading has relatively low-risk, that doesn’t mean that it’s zero. People should take into account that, without risk, there’d be no reward and trading is not an exception. However, thanks to this strategy it is possible to minimize the risk. People should pay attention to this trading strategy.