The Important Technicalities of Arbitrage Trading That You Should Know
Editor’s Note: This article was originally published on Digital Journal, and has been translated into English.
Synopsis: Arbitrage trading provides low-risk benefits to traders who are able to key into this strategy and make it work. However, it is important that traders understand the different types of arbitrage and how they are carried out in forex and cryptocurrency, first. Even experts acknowledge that a keen acumen is required to take advantage of the difference in prices available for the same asset being offered on different exchanges.
Understanding Currency Arbitrage
Currency arbitrage is a strategy used in forex trading, where a trader which is a currency trader takes advantage of different spreads offered by brokers for a particular currency pair by making trades. This form of arbitrage involves the exploitation of the differences in prices quoted on an exchange platform, instead of paying attention to the price movements in the market. These are two of the commonly used types of currency arbitrage in the markets today: simple or two-currency arbitrage and triangular arbitrage. There is a third form of currency arbitrage, known as statistical arbitrage trading, but the core focus will be on the two simpler forms of trading in this space:
Simple arbitrage focuses on the exploitation of the pricing gaps found in different exchanges between the same asset. This happens, often, when two exchanges with the same asset quote said asset differently.
In terms of Forex, an example would look like this:
Exchange A is selling €1 for $1.5 and buying €1 for $1.8
Exchange B is selling €1 for $1.8 and buying €1 for $2.1
Here, a savvy trader could buy Euros from exchange A, which is selling at a much lower price at $1.5, and immediately sell these Euros on exchange B for much higher. The same can be said in an example from an Alpha Roc report:
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, according to the report, a trader could purchase ETH from the first exchange (exchange A), as it is selling it for a lower price, and then move immediately to sell the ETH to exchange B for the higher price stated.
If the trader makes this trade with 10 BTC, they could quickly earn a profit of 3 BTC in no time. However, for this to be successful the trader must act fast. When they spot such discrepancies in an exchange, if they don’t move quickly, another trader will spot this arbitrage opportunity, the market will adjust the pricing immediately, and the opportunity will be lost. One of the reasons why arbitrage trading may not be ideal for beginners is because of the speed and attention required to execute this strategy successfully.
There is a notable difference between these two strategies. When it comes to simple arbitrage, only two assets or currencies are involved, whereas triangular arbitrage involves three or more currencies. This type of arbitrage is the result of an inconsistency between the three or more different currencies that occurs when the currency’s exchange rates do not exactly match up.
To help you understand this type of arbitrage better, consider this forex-related example.
A trader chooses to 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
If you subtract the initial investment from the final amount: $1,001,373 — $1,000,000, you will get $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. As mentioned before, it will take time for novice traders to understand the technicalities of arbitrage trading.
How Arbitrage trading is used in Forex and Crypto
Arbitrage trading is a versatile strategy that can be applied to different types of assets, such as:
Forex arbitrage is the skill of taking advantage of price inconsistencies in the forex market. This may be implemented in different ways, but whatever method was used to carry it out, arbitrage seeks to purchase and sell currency prices that are currently divergent but too likely to come back together rapidly. The expectation is that as the price moves back to the mean (average), arbitrage trading becomes more profitable and can sometimes be closed within a matter of milliseconds.
This form of arbitrage is the simultaneous buying and selling of a digital currency to gain profit from the market inconsistencies. Cryptocurrency arbitrage is a type of trading strategy that profits from the exploitation of the price inconsistencies of the same coin on varying cryptocurrency exchanges. This kind of arbitrage can only exist as long as the market is inefficient. Most people who use cryptocurrency arbitrage take advantage of triangular arbitrage.
The Bottom Line
One of the reasons why traders lean towards arbitrage trading, despite its complex nature, is because of the low-risk profit one can gain from it. Opportunities for arbitrage are usually short lived as the market often balances itself out in terms of buyers and sellers once an inefficiency is found by traders, and this could put off newer traders who are trying to understand the concept.
But with any form of trading, it is important that time is set aside to study this strategy before seeking to gain profits. Reaching out to experienced traders and brokers to gain key insights from their respective methodologies is always encouraged.