Crypto Terms

What Is Arbitrage Trading and How Does Arbitrage Trading Work?

Arbitrage trading is a type of trading method that tries to make money by simultaneously purchasing and selling an item in two different markets. Most frequently, this is done between identical assets traded on several markets. Since these financial products are essentially the same asset, there should be no price differential between them.

Finding these pricing discrepancies and promptly trading them are both challenges faced by an arbitrage trader or arbitrageur. The window of profitability typically closes very quickly since other arbitrage traders are likely to notice this price difference (the spread) as well.

Additionally, while arbitrage deals often involve little risk, their gains are also typically modest. This means that arbitrage traders require a lot of funds in addition to the ability to move swiftly.

What kinds of arbitrage trading are available to bitcoin traders may be something you’re curious about. Let’s get right to it because several sorts can be exploited.

Types of Arbitrage Trading

Traders throughout the world profit from a variety of arbitrage tactics in a variety of marketplaces. However, several specific varieties are highly popular among bitcoin traders.

  • Exchange arbitrage

Exchange arbitrage is the most popular kind of arbitrage trading, when a trader buys the same cryptocurrency on one exchange and sells it on another.

Cryptocurrency prices may fluctuate swiftly. The prices are virtually never exactly the same at at the same moment when you look at the order books for the same item on many exchanges.

Trades in arbitrage are made at this point. They attempt to profit from these slight variations. Since pricing maintains a very narrow range across several trading venues, this in turn increases the efficiency of the underlying market. Inefficiencies in the market might, therefore, present an opportunity.

In practice, how does this work? Assume there is a pricing discrepancy between Binance and another exchange for Bitcoin. If an arbitrage trader notices this, they will want to purchase Bitcoin on the lower-priced exchange and sell it on the higher-priced exchange.

Of course, time and execution are critical. Bitcoin is a somewhat established market, with exchange arbitrage chances often having a very narrow window of opportunity.

  • Funding rate arbitrage

Trading in funding rate arbitrage is another popular arbitrage strategy used by traders of cryptocurrency derivatives. This occurs when a trader purchases a cryptocurrency and uses a futures contract in the same cryptocurrency to hedge the price movement with a funding rate that is lower than the cost of doing so.

  • Triangular arbitrage

Triangular arbitrage is a different kind of arbitrage trading that is quite popular in the cryptocurrency market. A trader who sees a price difference between three distinct cryptocurrencies and trades them for one another in a loop is engaging in this form of arbitrage.

Triangular arbitrage is based on the notion of trying to profit from a cross-currency price discrepancy (like BTC/ETH). For instance, you might use your BNB to purchase Bitcoin, then Ethereum, and ultimately BNB to purchase Ethereum. An opportunity for arbitrage emerges if the relative values of Ethereum and Bitcoin differ from the values of each of those currencies with BNB.

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