An analysis report of arbitrage trading on various assets

An analysis report of arbitrage trading on various assets

With investments and trading, one strategy known is arbitrage which allows traders to lock in gains by concurrently buying and selling identical assets, such as commodities, currencies, securities, and cryptocurrencies across two different markets and exchanges. This technique lets traders capitalize on the price differentials on the same asset across two different markets, known as market inefficiencies.

What is arbitrage?

The simplest form of arbitrage trading is buying an asset in an exchange or market where the price is lower and simultaneously selling it in the market where the asset’s price is much higher. It is a widely used investment and trading strategy and considered as one of the oldest strategies that ever existed.

This strategy is closely related to market efficiency theory. According to this theory, for markets to be perfectly efficient, arbitrage opportunities should not be present, meaning all equivalent assets should have the same prices. The convergence of the prices in different markets measures the efficiency of markets.

According to the Capital Asset Pricing Model and Arbitrage Pricing Theory, arbitrage opportunities only occur when there are mispricings of assets. If these opportunities are fully explored and taken advantage of, the prices of these equivalent assets should converge.

How arbitrage trading works

Traders can use an automated trading system to help them fully enjoy the advantages of the arbitrage trading strategy. These automated trading systems use algorithms to spot pricing gaps, allowing traders to jump on an exploit in the markets before it becomes common knowledge and the markets adjust the pricing.

Types of arbitrage

Simple arbitrage

  • Exchange A is selling 1 ETH for 0.021 BTC and buying 1 ETH for 0.024 BTC
  • Exchange B is selling 1 ETH for 0.024 BTC and buying 1 ETH for 0.028 BTC

In this example, a trader could buy ETH from exchange A, which is selling it for a lower price at 0.021 BTC and immediately sell the ETH to exchange B for 0.028 BTC. If the trader makes this trade with 10 BTC, they could quickly earn a profit of 3 BTC in no time. However, the trader must act fast when they spot such discrepancies, or else if another trader spots this arbitrage opportunity, the market will adjust the pricing, and the opportunity will be lost.

Triangular arbitrage

To better understand this type of arbitrage, we will be using forex as an example. Traders will start with US$1million to trade with the following exchange rate: EUR/USD = 0.8631, EUR/GBP = 1.4600 and USD/GBP = 1.6939.

Using the exchange rate above, a triangular arbitrage works this way:

  • Sell USD for EUR: $1 million x 0.8631 = €863,100
  • Sell EUR for GBP: €863,100/1.4600 = £591,164.40
  • Sell GBP for USD: £591,164.40 x 1.6939 = $1,001,373
  • Subtract the initial investment from the final amount: $1,001,373 — $1,000,000 = $1,373

From these transactions, a trader would receive an arbitrage profit of US$1,373, assuming that there will be no taxes or transaction costs.

Arbitrage trading on various assets

Commodities arbitrage

Forex arbitrage

Cryptocurrency arbitrage

Summary

Image credit: Unsplash

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