September 24, 2021

How Does Arbitrage Work?

If we have a look at different market strategies, we found that arbitrage could work as one of the most profitable ones.

If we have a look at different market strategies, we found that arbitrage could work as one of the most profitable ones. Arbitrage is a very useful tool that helps us make a profit in different financial markets with differences in the price of the same asset. This trading strategy has been widely implemented in the cryptocurrency market. 

In this guide, we are going to share with you how arbitrage trading works and how you can start trading with this strategy. Furthermore, we tell you why it is important to know arbitrage trading and how you can improve your trading profits with it. 

Disclaimer: the information shared by AltSignals and its writers should not be considered financial advice. This is for educational purposes only. We are not responsible for any investment decision you make after reading this post. Never invest more than what you are able to lose. Always contact your professional. financial advisor.

How Does Arbitrage Work?

Arbitrage trading is a type of trading strategy that allows users to make profits with the difference in prices of the same assets traded in different platforms or places. Although arbitrage could be used in different industries (retail, technology and finance), it is usually used by cryptocurrency traders. 

Arbitrage would require users in the cryptocurrency market to purchase a cryptocurrency in an exchange for a determined price and sell it for a higher price on another platform. This can happen because the market has different exchanges that serve jurisdictions with different supply and demand balances. 

This is why it is possible nowadays to make arbitrage trading in the cryptocurrency market. This can also be done using not only Bitcoin (BTC), the largest cryptocurrency in the world, but also other digital currencies. 

However, when doing arbitrage trading, you should closely calculate whether it would be profitable for you to process this trade or not. Remember you have to pay trading and withdrawal fees, something that could reduce your profitability. 

Is Arbitrage Illegal?

Arbitrage is not considered illegal, however, you should understand whether there are specific regulations in your country that limit these activities. That being said, arbitrage is mostly a legal activity in several jurisdictions and it is encouraged in many cases. 

This type of strategy is very useful to provide liquidity in different markets and also bring efficiency to the whole crypto industry. For example, it is possible to provide liquidity to a market that has higher demand moving this liquidity from markets that have lower demand.

This situation generates a general equilibrium in the markets. In this way, investors are paid for carrying out these arbitrage activities. Some markets are usually more inefficient than others, this is why it could be even easier to find arbitrage opportunities. 

Take into consideration that some jurisdictions might have some limits to arbitrage trading. Thus, you should closely follow and understand which are the limits imposed for you to conduct arbitrage trading strategies. 

How to do Arbitrage Trading? Example

Let’s use a clear example of how arbitrage trading works in the cryptocurrency market. 

We purchase Bitcoin (BTC) at exchange A for a price of $10,000. After it, we immediately realize that in exchange B, Bitcoin is being traded slightly higher for $11,000. Although most price aggregators on the crypto market would show an average (depending on trading volume) of BTC price, there are differences across exchanges. 

We would then move our BTC from exchange A to exchange B. Take into account that to move our BTC, we have paid the trading fee of $10 and we have also paid a withdrawal fee of $20. The network transaction fee was just $1. 

Once our BTC reaches exchange B, we can sell it for $11,000. This platform has also a trading fee for which we paid $11. The total cost of this trade was as follows:

  • Trading fees (A): $10
  • Withdrawal fees (A): $20
  • Trading fees (B): $11
  • Total (A + B): $41
  • Total profit: $959

The goal is now to send the funds we received on platform B to platform A once again and repeat the whole process. Nonetheless, this is a process that could take longer as cash withdrawals take usually longer to be processed. Instead, if the whole process is done using stablecoins, then we might have the possibility to repeat the whole trade as long as the difference in the price remains. 

Although in this example there was a profit of $959, the reality looks different. In general, price differences are smaller and they tend to be closed very fast. Thus, this trading activity should be done with trading bots and using exchanges that have low fees.

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