Arbitrage trading is the act of buying and selling an asset to make a profit from the price difference between the same asset sold in two different markets. A trader buys an asset from one market at a lower price and sells the same asset in a different market at a higher price to make a profit based on the price inconsistency.
Arbitrage shows that not all markets have the same level of efficiency in following price fluctuations based on valid market trends. With advancing technology, however, it is becoming more difficult for traders to capitalise on arbitrage trading in the long run. Two markets may notice the price inconsistencies and decide to react and remove the opportunity to cash in on the price imbalance by balancing the prices to the same market value.
Traders can also take advantage of advanced technology and spot these price inconsistencies just in time to make a profit based on the discontinuation of price trends between different financial markets. Moreover, traders may use automated systems for arbitrage trading, enabling swift moves from buying to selling an asset to make a profit.
Arbitrage trading is popular among traders because it is not affected by price fluctuations but rather by inconsistencies in the price of a single asset in two or more markets. While the risk in arbitrage trading is low, the time of exposure for these inconsistencies is equally low. Therefore, traders must act promptly to make a profit and capitalise on the price difference.
How Arbitrage Trading Works
Due to the unequal efficiency of different markets, price imbalance may appear as a great, riskless opportunity for traders looking to take advantage of inconsistencies in the value of an asset. That way, they can cash in on the difference between the price of a bought asset and the selling price. Arbitrage doesn’t allow these price fluctuations to last for long, which means that traders need to follow these inconsistencies closely and act swiftly to increase their net profits. To assure satisfying profits, traders also need to include the fees for buying and selling assets, and these fees vary from one financial market to another.
For example, let’s say a trader has spotted the chance to cash in through arbitrage trading in the cryptocurrency market. Bitcoin’s price is set at $8,000 by one specific market. The trader would need to make sure that the price of Bitcoin is higher on a different financial market. Let’s say that a market has Bitcoin listed at $8,200. To cash in on the opportunity, that trader can buy the Bitcoin for $8,000 on the first market and sell it for $8,200 on the secondary market. The profit would be the price difference between two different markets ($200), minus the fees. The higher the difference and the lower the fees, the higher the net profit would be. Even though arbitrage trading is practically riskless, the technology allows these markets to synchronise their prices for the same asset once a price fluctuation is noted, removing the opportunity for a trader to cash in on a price imbalance. However, traders can also take advantage of advanced technology by using instruments that allow them to spot these inconsistencies and act promptly to cash in on the opportunity.
The higher the funds invested in a trade, the higher the profits. However, traders need to be sure that they can perform a quick buy and sell an asset.
How Triangular Arbitrage Works
Triangular arbitrage, is also known as cross-currency arbitrage or three-cross arbitrage. Triangular arbitrage is a rare occurrence in the market, but it can offer a risk-free opportunity for traders to maximise their gains from the difference between an undervalued market and an overvalued market.
In the case of triangular arbitrage, traders are looking to make a profit from the difference between exchange rates of three different currencies (crypto or fiat). When the market’s cross-exchange rate doesn’t match a quoted exchange rate, traders can make a profit by exploiting the inefficiencies of different markets. Like arbitrage, traders will also look into exchanging currencies under lower exchange rates to assure maximum profits.
While triangular arbitrage opportunities are fairly rare, most traders who make a profit by exploiting the inefficiencies of different markets usually use advanced computers and tools to spot these opportunities and make their move. For example, a trader exchanges BTC for ETH, previously noting inconsistencies in the quoted rates and cross-exchange rates. The trader can then exchange ETH for XRP and then exchange XRP for BTC. The same model can be applied to fiat currencies: EUR could be exchanged for USD, USD for GBP, and finally GBP for EUR.
The price differences between exchange rates are usually very small, which is why traders need to trade large volumes to make a profit and capitalise on the opportunity.
Manual and Automated Arbitrage Trading
Arbitrage and triangular arbitrage can be conducted either manually or automatically. For manual arbitrage, traders must spot the met criteria, predict when these criteria could be met, and then set an entry and exit point to assure profits. For automated processes, the chances for conducting an arbitrage or triangular arbitrage trade increase because traders can create a set of rules under which an automated bot will respond with buy and sell actions when the criteria are met across financial markets.
Automated arbitrage trading needs to be defined by traders. Trades occur at a rapid pace, which is why automation is recommended. Another advantage of automated trading is the ability to test a set of rules for arbitrage criteria based on historical data before investing funds in a trade.