Arbitrage trading attracts traders due to its simplicity—it involves finding assets trading at different prices across multiple markets to secure a profit. However, just like any trading method, it carries both profit potential and risk.
Emerging markets with lower liquidity and weaker regulation often present the best opportunities for individual arbitrage traders. For instance, the cryptocurrency market is less efficient than the stock market, making it particularly suitable for arbitrage.
In this article, you will learn about various forms of arbitrage, explore popular trading strategies, and identify the conditions under which retail traders can benefit from arbitrage.
What Is Arbitrage?
Arbitrage aims to profit from price discrepancies of the same asset. Traders sell the asset on a platform where it trades at a higher price and simultaneously buy it on a platform where it is priced lower.
This concept isn’t limited to financial markets. For example, physical retailers practice arbitrage when they buy products in one country at a low price and sell them in another country at a higher price.
Arbitrage trading can involve stocks, currencies, derivatives, and cryptocurrencies. If a company’s stock trades at $5 on the New York Stock Exchange and $4.7 on the London Stock Exchange, this creates a potential arbitrage opportunity—provided that the profit exceeds transaction costs.
Speed is often critical in arbitrage trading. Powerful computers, high-speed internet, and automated trading programs can be advantageous. Manual arbitrage may still be profitable in emerging markets like cryptocurrency, whereas it is more challenging in developed, efficient markets such as equities.
What Is Crypto Arbitrage Trading?
Crypto arbitrage involves executing opposite trades on the same cryptocurrency across different exchanges. To engage in crypto arbitrage, you need to have funds deposited on at least two cryptocurrency exchanges.
The cryptocurrency market is highly volatile, leading to larger price discrepancies compared to stock or forex markets. Additionally, due to lighter regulatory oversight, liquidity can be lower, causing price gaps to persist longer. These conditions create opportunities for traders to profit from arbitrage, even manually.
The core idea is to identify situations where the same cryptocurrency is priced differently on two exchanges. By selling at the higher price, arbitrageurs increase supply, pushing the price down. Simultaneously, buying at the lower price boosts demand and drives the price up. Thus, the more arbitrage occurs, the smaller the price gap becomes. Successful crypto arbitrage requires quickly identifying and acting on these opportunities.
Risks in Crypto Arbitrage Trading
The primary risks in crypto arbitrage are security and timing.
As participants in exchange trading, crypto arbitrage traders are exposed to potential hacking and fraudulent activities by exchanges. Dishonest brokers might also abscond with client funds. Given the limited legal oversight in crypto markets, it is crucial to prioritize security—choose reputable brokers and use additional verification methods to protect your account.
Timing risk is another critical factor. Traders can perform crypto arbitrage in two ways:
- Mechanically, by investing in powerful trading hardware and high-speed communication tools.
- By using automated scanners to identify arbitrage opportunities and specialized programs to execute trades.
The longer it takes to act on an arbitrage opportunity, the more traders will buy low and sell high, reducing the price gap and potential profit. At some point, the profit may no longer cover the costs.
Costs include various commissions paid during arbitrage, such as trade execution fees, inter-exchange transfer fees, or withdrawal charges.
Example of an Arbitrage Trade
Consider this example of a cryptocurrency arbitrage trade:
- Exchange 1 balance: 15,000 EUR + 1 Bitcoin.
- Exchange 2 balance: 15,000 EUR + 1 Bitcoin.
- Bitcoin price on Exchange 1 = 15,000 EUR.
- Bitcoin price on Exchange 2 = 15,100 EUR.
After buying 1 Bitcoin on Exchange 1 and selling 1 Bitcoin on Exchange 2, the trader’s balances become:
- Exchange 1: 2 Bitcoins.
- Exchange 2: 30,100 EUR.
The profit is 100 EUR. However, the trader now holds only Bitcoin on Exchange 1 and only EUR on Exchange 2. To continue trading, they must transfer Bitcoin from Exchange 1 to Exchange 2 or move EUR in the opposite direction, incurring additional transfer fees. These costs must be factored into the net profit calculation.
Types of Arbitrage
Several types of arbitrage exist:
- Pure arbitrage, common in investment and financial markets.
- Retail arbitrage, involving physical goods.
- Merger arbitrage, related to corporate acquisitions.
- Convertible arbitrage, involving convertible bonds.
- Triangular arbitrage, used in forex and crypto markets.
- Latency arbitrage, which exploits price delays between trading platforms.
Pure Arbitrage
Pure or spatial arbitrage occurs when the same asset trades at different prices across markets. For example, large-cap stocks like Sony may trade on multiple exchanges. If Sony is cheaper on the Tokyo Stock Exchange (TYO) than on the New York Stock Exchange (NYSE), a spatial arbitrage opportunity arises: buy on TYO and simultaneously sell on NYSE.
Pure arbitrage can also apply to currencies and cryptocurrencies. During overlapping trading sessions, such as when the U.S. market opens before the European market closes, the euro may trade at different prices.
In crypto, price gaps can emerge between high-liquidity and low-liquidity exchanges. For instance, Bitcoin might be quoted at 16739.07/16739.56 on Binance and 16740/16742 on Bitfinex. A trader could buy on Binance at 16739.56 and sell on Bitfinex at 16740.
However, with the rise of automation, such price discrepancies are shrinking, making pure arbitrage—especially manual—increasingly rare.
Retail Arbitrage
Retail arbitrage involves physical goods. A trader might buy a product in a local market and resell it at a higher price in another city or country.
The end buyer benefits because the price premium is lower than the cost of traveling to purchase the product directly. Since the selling transaction occurs after the purchase, the profit compensates for several risks: demand uncertainty and the challenge of reselling at a favorable price.
Merger Arbitrage
This type of arbitrage arises when a public company acquires another. The acquirer typically offers to buy the target company’s shares at a premium to the market price. When the acquisition is announced, arbitrageurs buy the target’s stock, expecting the price to rise toward the offer price.
However, the deal might fail due to regulatory blocks or other reasons. Thus, the arbitrageur assumes the risk that the acquisition may not complete. The greater the spread between the current price and the offer price, the higher the potential profit—and risk.
The opposite strategy—shorting the target’s stock—can profit if the deal collapses and the share price falls. However, this carries unlimited risk and is not pure arbitrage.
Convertible Arbitrage
Convertible arbitrage involves convertible bonds, which can be converted into the issuing company’s stock. These bonds typically offer lower interest than traditional bonds but provide conversion options.
Arbitrageurs might buy convertible bonds and short the underlying stock, profiting from mispricing between the two. Risks include changes in the company’s credit rating or delays in conversion rights.
If the bonds are overbought, traders might instead buy the stock and short the bonds.
Triangular Arbitrage
Triangular arbitrage exploits pricing discrepancies among three currency pairs. For example, consider BTC/USD, ETH/USD, and BTC/ETH.
If the cross rate between BTC and ETH implied by BTC/USD and ETH/USD differs from the actual BTC/ETH rate, an opportunity arises. The trader executes three trades to profit from the mispricing.
For instance, if BTC/USD = 16716, ETH/USD = 1216, the implied BTC/ETH rate is 16716/1216 ≈ 13.75. If the actual BTC/ETH rate is 13.8, the trader can buy BTC/USD, sell BTC/ETH, and sell ETH/USD to lock in a profit.
If the actual rate is lower than implied, the trader would reverse the trades.
Latency Arbitrage
Latency arbitrage, or high-frequency arbitrage, uses ultra-fast algorithms to exploit tiny price delays between platforms. Traders invest heavily in technology and infrastructure to execute trades within milliseconds. This method is highly technical and requires significant resources.
Pros and Cons of Arbitrage Trading
Speed is a critical factor in arbitrage success. The faster a trader identifies and acts on an opportunity, the higher the profit potential. Manual traders often struggle to keep pace.
Advantages of Arbitrage
Clarity
Unlike subjective chart analysis, arbitrage focuses on concrete price differences.
Reduced Uncertainty
In standard trading, outcomes are uncertain. In arbitrage, success depends primarily on execution speed.
Disadvantages of Arbitrage
Costs
Profitable arbitrage often requires expensive software or infrastructure. Manual opportunities are scarce.
Execution Risks
Slippage, requotes, and connectivity issues can negate profits, especially since arbitrage gains are typically small.
Arbitrage Trading Strategies
Here are three strategies that don’t require ultra-high speed:
Risk Arbitrage Strategy
This strategy involves buying shares of a company being acquired at a premium. The profit is the difference between the market price and the acquisition offer price. The risk is deal failure.
Fixed-Income Arbitrage
This strategy exploits yield disparities between similar securities, such as bonds from the same sector. Traders assume yields will converge.
Covered Interest Arbitrage
This strategy uses interest rate differences between countries. Traders borrow in a low-rate currency, convert to a high-rate currency, and earn the interest spread. Currency risk can be hedged with forwards.
Arbitrage Opportunities in the Stock Market
Five common equity arbitrage opportunities exist:
- Inter-Exchange Arbitrage: exploiting price gaps for the same asset across exchanges.
- Cross-Sector Arbitrage: trading correlated stocks within an industry.
- Cash-and-Carry Arbitrage: exploiting price differences between an asset and its derivative.
- Calendar Arbitrage: trading futures contracts with different expirations.
- Statistical Arbitrage: using mean reversion principles to trade overbought and oversold stocks.
How to Start Arbitrage Trading
To begin arbitrage trading:
- Decide between manual and automated trading.
- Choose a market, considering costs and commissions.
- Compare potential profit to costs.
- Identify and mitigate risks.
- Practice on a demo account.
- Test with small live trades.
- Scale up if results are satisfactory.
Conclusion
The main challenge in arbitrage is choosing between investing in technology or developing skills. Automated trading requires more capital or higher frequency to achieve returns. Manual arbitrage, with lower speed demands, can be pursued with standard capital.
Like all trading, arbitrage involves risk. The cryptocurrency market remains favorable for both manual and automated arbitrage due to its relative inefficiency and lower competition.
Frequently Asked Questions
What is a simple example of arbitrage?
Buying euros on the London Stock Exchange at a lower price and simultaneously selling them on the New York Stock Exchange at a higher price, with equal trade volumes.
Is arbitrage trading legal?
Yes, it is legal and often benefits markets by improving liquidity.
How does arbitrage work?
Traders buy an asset cheaply in one market and sell it expensively in another. Profit is locked in by either closing both positions at the same time or transferring the asset to cover the sale.
Is arbitrage easy?
Theoretically, yes. Practically, it requires skill to find opportunities, manage costs, and execute trades quickly, especially as markets become more efficient.
Can you lose money with arbitrage?
Yes, if the price of the bought asset falls more than the sold asset rises, or if transfer costs exceed the profit.
When can you enter an arbitrage trade?
When the same asset trades at different prices across markets or liquidity providers.
Is arbitrage possible in the forex market?
Yes, but due to low margins, it often requires substantial capital. Traders must also find opportunities where profit exceeds costs.
Is crypto arbitrage better than stock arbitrage?
Crypto markets are less efficient, offering more opportunities. Stock markets are highly efficient, making arbitrage harder.
How do I start arbitrage trading?
Open trading accounts, learn to identify price discrepancies, and act quickly. Speed is proportional to profit.
What is crypto arbitrage?
Buying a cryptocurrency on one exchange at a low price and simultaneously selling it on another exchange at a higher price.
Why is arbitrage popular?
Opportunities arise daily, and risks are often lower than in directional trading. Traders don’t need unique strategies—just a good scanner and fast execution.
Are there risks in arbitrage?
Yes, including execution risks like slippage and requotes. Since profits are small, even minor price changes can impact results.
How do I find crypto arbitrage opportunities?
Compare prices for the same cryptocurrency across multiple exchanges. Buy low and sell high simultaneously.
How does triangular arbitrage work in forex?
It involves three currency pairs. For example, if EUR/USD = 1.10 and AUD/USD = 0.68, the implied EUR/AUD rate is 1.10/0.68 ≈ 1.62. If the actual rate is higher, buy EUR/USD, sell AUD/USD, and sell EUR/AUD. If lower, do the opposite.
What are the conditions for profitable arbitrage?
Price discrepancy for the same asset and profit exceeding transaction costs.
What is the law of one price?
It states that identical assets should have the same price globally. Arbitrage helps enforce this by buying low and selling high.
Why do price discrepancies occur?
Due to varying liquidity across markets and delays in price feeds caused by distance or technology.
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