How Exactly Does Crypto Arbitrage Trading Work?

Written by Evan Francis, CEO & co-founder of Coygo Inc. which provides tooling for professional cryptocurrency trading and insights. A cryptocurrency advocate since 2010, Evan has years of experience working as a software engineer in fintech before leaving his corporate job to pursue a full-time venture in the cryptocurrency and digital asset space.


You may have heard of people mention arbitrage trading from time to time, but do you really understand how it works? Let’s dive into the different approaches to arbitrage, and how it works when trading crypto.

What Is Arbitrage

Arbitrage is defined as “the simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset.” In simpler terms, it means that a trader purchases some asset (for example BTC) then sells it for a higher price on a different exchange or trade pair. There are a few different ways to do this, each with their own upsides and downsides.

1.png

Why Are There Price Differences?

In order to profit off of arbitrage there needs to be a difference in price across exchanges or markets. For example, 1 BTC might be sold for $8,000 on one exchange and $8,100 on another. Why is there a price difference? This is because exchanges don’t have a set price for any asset, they maintain an order book which is a list of all of the prices that other people are willing to buy or sell that asset (because they have open buy or sell orders that are waiting to be filled). When you want to buy BTC on an exchange, you will buy it for the lowest price that someone is willing to sell it for, say $8,000. If there is nobody else looking to sell BTC for at a rate of $8,000, then the next lowest selling price will be used. That would depend on what other people have opened orders for, it might be $8,000.10, or $8005. Due to this mechanism, prices are always changing.

How Can I Find Price Differences?

Finding a big price differences, or “spread”, that you can take advantage of for profit can be hard. You need to be constantly watching real-time ticker (price) data across a number of exchanges, and doing the math to figure out how big the spread is. A spread of 0.10% probably won’t be profitable due to exchange trading fees, but a spread of 3% or so could be used to easily make a profit.

In reality, you’ll want to use some type of tool or custom spreadsheet to find spreads in real-time. These are often called a “crypto arbitrage scanner” or something similar. Profitable opportunities sometimes only exist for a short amount of time so having assistance in finding these spreads is crucial. There are a number of options to help with this, such as Coygo or ArbiTool. Below is an example of an arbitrage scanner.

arbitrage

How Do I Make Profitable Crypto Trades Using Arbitrage?

Now that you’re able to find a sizeable spread, it’s time to place your trades and (hopefully) make a profit. There are a few ways to perform arbitrage, I will describe two different options.

Inter-Exchange Arbitrage With Transfers

This is probably the most commonly discussed approach. You buy an asset on one exchange with a lower price, transfer it to another exchange where it’s being sold for more, then sell it on the second exchange.

This can be dangerous and unpredictable because transferring crypto can take time (for example Bitcoin transactions settle in 10 minutes on average) and there are transfer fees that must be considered as well. By the time your transfer completes to the second exchange the price spread may no longer be big enough to make a profit, or your transfer fee might negate any potential profit.

Inter-Exchange Arbitrage Without Transfers

A faster and more reliable option is one that doesn’t involve transferring between exchanges, but the caveat is that you must already hold the asset you’re selling on the first exchange that you want to buy on, and you must already hold the asset that you’re buying on the second exchange that you want to sell on.

Say you found a spread in the DASH-ETH markets on two exchanges. You’re going to be buying DASH with ETH on exchange A, and selling DASH for ETH on exchange B. So you must already be holding ETH on exchange A, and DASH on exchange B. When there is a profitable spread between the two exchanges you can place a buy on exchange A and an accompanying sell on exchange B. You have now increased your portfolio’s overall value, it’s just spread across two exchanges.

Intra-Exchange Arbitrage (All on the Same Exchange)

This involves performing arbitrage all within the same exchange. You find spreads between three different assets. Let’s take a theoretical example scenario: BTC-USD is being traded for $8,000, BTC-LTC is being traded for 50 LTC. You would think that LTC would then be traded for $160 ($8,000 / 50), but the LTC-USD is actually trading at $175. This is a spread that you can exploit with arbitrage.

One can buy 1 BTC for $8,000 on the BTC-USD market. Then trade your 1 BTC for 50 LTC on the BTC-LTC market. Then you can sell your LTC for $8,750  (50 LTC x $175) on the LTC-USD market. You started with $8,000, and after three trades you now have $8,750, a 9.4% profit.

Liquidity Is Important

There are some things that you should keep in mind when looking to make a profit with crypto arbitrage. First, a spread might look profitable (some tools like to advertise how they can find a 30% spread), but if there is no liquidity you won’t actually get that much in profit. If there is a thin order book you might only get $10 worth of BTC at the “last” price which was used to calculate the profitable spread, then the rest of your order will eat through the order book and you could end up paying a very unappealing price. In general you should stick to markets that have decent liquidity. A quick glance at a depth chart should give you a good idea of a market’s liquidity.

3.png

Use the Right Tools

Another thing to note is that many other people and bots are trying to exploit these arbitrage spreads, so they won’t last long. For that reason, you'll probably want to use a tool to help assist you in placing these trades. You don’t want to be bouncing between a bunch of different windows placing trades when your speed determines if you make a profit or not. There are a number of different tools out there that can help with trading on multiple exchanges at once.

Hopefully you’ve got a good grasp of how arbitrage works and how you can use it as a tool to make a profit. Crypto trading can be a profitable game if done right, good luck with your trading!

Featured image via Unsplash