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What is arbitrage? - What You Need To Know

 

By Nerly Shammah Sep 12, 2022

 

 

Arbitrage has to do with a trading strategy that involves the purchase and layoff of assets in different markets or the same market but different trading pairs, taking advantage of its slippage or price difference to make a profit.

 

It is considered healthy as it aids in market stability, however, a wide price difference can lead to a massive exploit, thus a market crash.

 

Arbitrage trading is one of the less-risky trade methods, considering that a trader only has to buy and sell these financial assets immediately. What makes it different and less risky is the fact that trade transactions are to be immediate, and most often need quick actions as prices don't always stay profitable for long.

 

 

Understanding Arbitrage

 

The financial markets, most commonly the digital assets markets, are all just a huge pill of value networks providing diverse opportunities to generate income or make a profit. It is often said that when one learns how to leverage the markets despite the season, one is considered a successful investor or trader. 

 

Markets tend to operate in circles, moving through bullish seasons where prices of assets increase exponentially and then to bearish seasons where the markets tumble and many people get rekt.

 

In between all these circles are constant patterns or events, one of many being the fluctuation of asset prices. Using cryptocurrencies as a case study, these forms of assets are highly volatile, which makes them even vulnerable to price swings.

 

Arbitrage is a product of market inefficiency, when an asset market cannot keep a uniform price feed across all exchanges, arbitrage occurs. Typically, this may be an exchanger's fault or may be due to the nature of the asset's liquidity. The most exposed assets are illiquid and thus, easy to manipulate.

 

Arbitrage is considered an exploit - which of course isn't illegal, it's a fair trade practice, and it is also seen as a stability mechanism. Typically, when prices swing and cause huge differences across markets, traders arbitrage, at some point, the markets become the same due to this activity, this process helps the market reclaim uniformness.

 

What Are The Types Of Arbitrage?

 

There are numerous arbitrage strategies to say, a couple including risk, retail, convertible, negative, statistical, and triangular arbitrage, a more commonly used method is simply called arbitrage between exchanges.

 

How Does Arbitrage Work?

 

Consider this example. Let's say a cryptocurrency like ether is trading at $3000 on Binance whereas on Kucoin ether is trading at $3020 a unit, this opens up an opportunity for traders to earn $20 just by buying ether on Binance and selling on Kucoin, the process is called arbitrage.

 

A more complex method of arbitrage may involve different assets, most often three, this is called triangular arbitrage and may require more price monitoring and calculations. Triangular arbitrage involves buying a said asset like ether, selling for bitcoin, then selling bitcoin for hive perhaps, and finally selling hive for ether.

 

This method may prove complex but can be very profitable if mastered. Arbitrage between trading pairs is also another strategy and considering the size of the cryptocurrency ecosystem, it can be very profitable as there are lots of marketplaces ranging from centralized exchanges(CEXs) to decentralized exchanges(DEXs) with different trading pairs of thousands of assets, tokens, and coins.