Arbitrage Trading – A Beginner’s Guide

Introduction

Chances of profit and loss are everywhere when you think of investment. It is hard to believe that there can be an option that provides you with almost 100% chances of profit and almost zero risk. Yet, such an option does exist. It is called arbitrage trading. Arbitrage trading is the simultaneous buying and selling of securities, currency, cryptocurrencies, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset.

The Concept Made Easy

To understand the concept from an example, let’s suppose that looking at the markets closely, you observe that there is a minute difference between the price of $BTC on Binance and Coinbase. Since the price of cryptocurrencies must be the same across all exchanges, you know that the exchange offering the low price must be having a temporary glitch, and that the price is going to match the higher version very soon. You take advantage of the price gap by buying at a lower price and selling at the higher one.

How Arbitrage Trading Works

However, the process raises many question marks. You may think whether it is possible for a trader to be so quick in shifting their assets between exchanges. And are there no transfer charges when the assets are shifted? When these charges are added to the trading fees of exchanges, are traders still able to earn anything?

The answer to the first question is that the margin of profit in arbitrage trading is very tiny. So, this option is generally considered only by those traders who have large amounts to invest. Even a very small fraction of a very large investment is enough to make the trade worthwhile. Such traders usually do not shift their assets. They already have funds on many exchanges where they buy and sell by means of rebalancing.

This answer automatically answers the second question: since there is no shifting involved, there are no such charges. The third point is that the trading fees are certainly there, but they do not hamper the profit taking. Such trading is generally carried out by high-frequency trading (HFT) firms that have sophisticated algorithms for this very purpose. These systems work speedily and efficiently.

The speed of executing an arbitrage trading is the most challenging thing. The price difference a trader sees is visible to everyone, so there are a large number of traders trying to utilize the opportunity.

Types of Arbitrage Trading

There are three types of arbitrage trading in the crypto market.

Exchange Arbitrage

When you observe an order book of a coin and compare it with the versions on different exchanges, there are very minor differences. In fact, the type of arbitrage trading discussed so far in this article is the exchange arbitrage. Suppose a trader observes that $BTC is trading at $118,234 on Binance and at $118,245 on Coinbase, they buy on Binance and sell on Coinbase. As mentioned above, the speed of trading is very important as even a second of delay can deprive a trader of the profit they were targeting.

Funding Rate Arbitrage Trading

Funding rate arbitrage is a common arbitrage tactic used by traders of cryptocurrency derivatives. In order to lower price risk, it involves holding a cryptocurrency, such as Ethereum, while simultaneously opening an opposite, but equal, position using perpetual futures. In order to keep perpetual contracts in line with the market, it is intended to ensure consistent revenue from the funding payments.

Let’s imagine that you hold 10 Solana and plan to keep it for the long term, but you’re worried about the price volatility. To protect your investment from short-term price swings, you open a short position in a Solana perpetual futures contract. This short position moves in the opposite direction of your spot holdings, so any losses on one side are covered by the gains on the other.

If the funding rate on that futures contract is positive, then traders who are long on $SOL must pay a fee to those who are short. As the short trader, you receive those payments. For example, if the funding rate is 1.5%, you’d earn 1.5% on the value of your short position, just for holding it.

Because your spot and futures positions cancel each other out in terms of price, you’re not exposed to market direction. Whether SOL goes up or down, the gain on one side cancels the loss on the other. Your net profit comes from the funding rate payments, as long as they exceed your trading fees. In simple words, you’re transforming your 10 SOL into a yield-generating asset by neutralizing price risk and collecting periodic payouts from the futures market.

You should keep in mind that this trade yields gains only when there is no leverage used because a leveraged position can easily be liquidated if there comes some major volatility in the market.

Triangular Arbitrage

Triangular arbitrage is another common crypto market strategy. This involves making the most of price differences between three different cryptocurrencies by exchanging them in a circular sequence.

The goal of such trading is to profit from inconsistencies between the prices of three coins. For example, a trader might start by converting $SUI to $BTC, then use that $BTC to buy $ETH, and finally convert the $ETH back into $SUI. If the exchange rates among these pairs are not perfectly aligned, the trader could end up with more $SUI than they started with, creating a risk-free profit opportunity. Therefore, it is always useful to look at the $BTC pairs in addition to looking at the $USDT pairs.

Conclusion

Arbitrage trading is perhaps the only option in the crypto market in which you can expect very low risk and almost 100% chances of profit. The condition is that it must be executed quickly enough. Exchange arbitrage, funding rate arbitrage and Triangular arbitrage are three popular forms of arbitrage trading. The key point remains the same: exploiting the differences in prices on different exchanges, different coin pairs, or different price movements.