Arbitrage is one of the safest trading strategies out there. Many crypto millionaires made their first fortunes by monitoring the markets and finding ways to profit from market inefficiencies. Experts believe that this strategy is quite reliable and consistent, but it has only a handful of downsides. On the other hand, opportunities for cryptocurrency arbitrage appear rare due to fast price convergence.
According to some studies, using this approach in intraday trading can result in annualized returns of over 6.57% when applied to the stock market. While this number may not seem too high, we must remind you that risk premiums depend on the safety of any given strategy. In this case, you are not exposed to risks as much as in many other strategies and naturally receive a smaller risk premium.
Arbitrage trading strategies
Several types of arbitrage exist. Retail traders usually engage in direct arbitrage where assets are exchanged to exploit price differences. Institutions are more interested in running complex systems like statistical arbitrage where an investor seeks correlations between different assets to identify whole groups of stocks or tokens to invest in.
Let’s talk about different types of these strategies and touch upon the impact of market trends on the viability of arbitrage strategies:
- Pure arbitrage is the foundational approach to this strategy. Investors buy assets in one market and sell in another where the price is higher. It works well on a global scale. For instance, the now-infamous founder of the FTX exchange made his fortune by buying Bitcoin in the US market and selling it in Japan making huge returns overnight. Today, price convergence is very fast, and exploiting minute discrepancies can be quite hard.
- Triangular arbitrage is an approach that involves using three pairs of assets that share at least two assets. For instance, you could track BTC/USDT, ETH/USDT, and BTC/ETH. Here, any discrepancy between prices against a base currency (let’s say, USDT) can be immediately exploited by making a three-way trade. This method works when you focus your attention on a single trading platform. The answer to the question “How do I invest in cryptocurrency?” often starts with learning triangular arbitrage.
- Cross-exchange arbitrage is a strategy that involves derivatives. Different exchanges may not produce massive differences between the base prices of digital assets. Bitcoin costs the same across multiple platforms and prices rarely diverge. However, futures contracts can have discrepancies that are easier to exploit. However, you will need to take on an additional level of risk due to using leveraged market positions.
- Statistical arbitrage is used by large investment institutions like banks and funds. Today, individual retail traders can use it too thanks to the abundance and accessibility of automated trading bots that can run such systems on your behalf. Automation is used to run all arbitrage systems due to higher reaction and execution speeds, but statistical arbitrage requires the workforce to make adjustments to a massive portfolio that can contain hundreds of positions at once.
The main goal of an arbitrage strategy is to extract profits safely without exposing capital holders to excessive risks. You make a trade only when a price discrepancy is identified and make tiny profits to instantly exploit it before the market converges to the same price across the board eliminating an opportunity.
Risks of cryptocurrency arbitrage
The risk premium is very low in this strategy precisely because you don’t overexpose your portfolio. However, the dwindling number of arbitrage opportunities makes it hard to utilize the strategy to extract meaningful returns efficiently and reliably.
Below are some risks associated with this strategy:
- Issues with liquidity in crypto markets. While trading on CEXes is usually not affected by liquidity as large centralized exchanges have the necessary volume and large-scale liquidity providers to cover massive deals, decentralized exchanges may suffer from insufficient liquidity and fail to close deals at target prices reducing potential profits.
- The prevalence of automation. According to some studies up to 65% of individual traders and over 99% of institutions use automation to at least some degree. It is a rare occasion to meet an arbitrager who does not use robots to execute their strategies. The whole predicament is an example of how technological advancements are enhancing arbitrage opportunities in cryptocurrency while simultaneously killing the market for many participants who do not use contemporary tech.
- Instant price convergence. One of the greatest risks in arbitrage is that prices can reach an equilibrium before you finalize a trade making it unprofitable. In digital crypto markets, the information about prices travels quickly, and thousands of arbitrages rush in creating a situation where arbitrage becomes the very reason for instant price convergence. Many experienced retail traders prefer working with relatively unknown assets where prices converge more slowly.
The absence of regulatory frameworks and potential technological failures are also significant risks. However, these can be largely ignored since many retail traders operating in the cryptocurrency markets are inherently ready for them.
On the other hand, one must remember two very important downsides of this strategy:
- Capital requirements. Arbitrage is a good approach for newcomers with large capital. Due to low-risk premiums, you can act confidently and make good money. However, returns will not feel impactful if your initial capital is too small to produce a meaningful result.
- You need to master all sorts of tools. The importance of real-time data and analytics in successful arbitrage trading as well as the use of automation is undeniable. To be competitive in this market, you have to learn how to use various instruments and employ robots.
A peculiar paradox of arbitrage strategies is that the risk level should be excellent for beginners, but capital requirements make it accessible only to investors with experience.
The future of cryptocurrency arbitrage
The biggest problem that many experienced retail traders observe is that the market rarely produces opportunities that can be exploited without automation. In fact, thousands of robots monitor all markets at once making it close to impossible for an individual to make a profit in the same markets. Even obscure tokens are often tracked by multiple bots.
Ethical aspects of arbitrage done by robots aside, an individual retail trader must be aware of all sorts of problems commonly associated with participating in the market directly. When it comes to DeFi platforms, difficult onboarding, imperfect software, and many other issues can make it difficult to run efficient arbitrage systems.
Instead, you could visit the yield marketplace at Rivo and check out a wide range of expert-picked strategies. You can find something that will work for any set of preferences and risk styles. Here, you can learn how to stay informed about new developments and tools in cryptocurrency arbitrage, new investment options, and exciting DeFi tools by talking to the Maneki AI agent, reading the blog, or simply exploring various strategies!
