Is it possible to arbitrage cryptocurrencies?
Strategy, focused on currency disbalance across different brokers, offering CFDs on crypto assets.
What is Bitcoin arbitrage?
The idea that each crypto exchange provides a particular price for Bitcoin gave rise to the concept of arbitrage. Crypto arbitrage is the practice of purchasing for example bitcoins at one market and selling them at another, where the price is higher.
Different Bitcoin exchanges often have different prices for given crypto asset, because of the way Bitcoin price is calculated, so certain individuals would continue to take advantage of this and make income from thin air. In this article we will clarify what crypto arbitrage is and how it is done.
Why do Bitcoin and cryptocurrencies have value?
Bitcoins and crypto assets in general are appreciated because they're useful as a form of money. They have the characteristics of money (durability, portability, fungibility, scarcity, divisibility and recognizability) relying on the properties of mathematics rather than on physical properties (like silver and gold) or confidence in central institutions (like fiat currencies). In short, Bitcoin and cryptocurrencies are powered by mathematics. With these characteristics, all that is needed for a type of money to retain it's value is confidence and acceptance. In the case of Bitcoin, this can be determined by its rising pool of users, traders and start-ups. Like for any currencies, the value of Bitcoin derives purely and strictly from individuals able to recognize it as payment.
How the price of cryptocurrencies is calculated?
Before we can think about arbitration (i.e. purchasing at a low price and selling at a higher price) we need to clarify what cryptocurrency price actually implies. In theory, the price of a crypto asset is determined by supply and demand. When demand for particular currency increases, the price increases, and when demand falls, the price falls. In practice on any crypto marketplace, the price of Bitcoin for example shall be determined by the last transaction made on that platform. Because various markets have different amounts of buyers and sellers with different priorities, it is normal that prices do not match 100%.
You can think of crypto exchanges as closed markets that are not explicitly connected. On top of this, certain platforms have very small trading volume, which makes Bitcoin's price far more competitive. As a consequence, certain people are attempting to purchase bitcoins "for free" on one platform and then offer them at a higher price on another platform.
Example of arbitrage in crypto markets
There is a gap in certain capital markets between the buying price and the selling price of an asset, which is called "spread". However, this specific instrument can be exchanged around the planet. Prices can fluctuate briefly, allowing an arbitrator the chance to make a profit by purchasing it in one market and selling in other markets.
Let's see a basic example of arbitration to explain how arbitrage is handled. Assuming the price of Bitcoin on Bitstamp is $11 500, whereas the price of Bitcoin on Bitfinex is $11 550. The cost differential is $50, and it is a good opportunity for arbitration. Let's suppose you 're purchasing 100 bitcoins on Bitstamp at $11 500 apiece, and then you're selling them on Bitfinex exchange for $11 550. You'd make $50 for every Bitcoin exchanged. If we multiply 100 Bitcoins by $50 you'll see that final profit is $5 000.
Pretty neat, but with one caveat, we need a relatively large amount of capital in order to make a substantial profit via arbitrage, in this example the capital needed is $11 500 x 100 = $1 150 000.
This inconvenience can be avoided if we are trading Bitcoins on margin - number of exchanges and forex brokers offer margin trading for crypto with leverage of 1:5, 1:10, 1:20, or even more.
Caveats of Bitcoin arbitrage on crypto exchanges
You'll certainly face some obstacles as you attempt to arbitrate:
- It can take some time to confirm transactions (to and from exchanges) and the price of Bitcoin could change during that period;
- Many exchanges demand substantial authentication steps in order to transfer a large quantity of bitcoins;
- Exchange fees, ignored in the above example, are going to eat away at your profits;
- The volume of transactions on both platforms must be large enough to meet these huge orders of purchasing and selling;
- Bear in mind that price fluctuations across exchanges can often represent technological problems or credibility concerns. An important illustration is what occurred in the last days in Mt. Gox, when the price of Bitcoin was suspiciously low as customers could not trust the exchange to permit them to withdraw their assets (i.e. there weren’t many buyers on the exchange).
Software used for crypto arbitrage
The above caveats can be avoided by using specialized software for arbitration and brokers, offering margin trading and CFDs on crypto assets. Since arbitrage trading conditions tend to persist for a rather short period of time (often just a few seconds or a minute), it is very time-consuming to make arbitrage calculations by hand or to execute trades manually on different exchanges. Traders therefore use advanced software arbitration tools that can immediately identify and, ultimately, quantify arbitrage opportunities. We can define three categories of software applications that are widely used for arbitrage trading:
- Automatic Trading Software
- Notification Programs
- Remote Alert Services
The first form of technology used in arbitration trading is algorithmic trading software. This sort of arbitration software is installed directly on a brokerage trading platform such as MetaTrader 4 or MetaTrader 5. Whenever the arbitrage trading program detects an arbitrage conditions, it shall immediately execute the necessary transactions on behalf of the trader.
Some traders tend to make the final FX trading decisions themselves, they may use market notification tools instead. Unlike automated Forex arbitrage trading applications, this category of software continuously checks different stocks, instruments or brokers for the purpose of arbitrage trading opportunities. If such an opening is found rather than the transaction being carried out automatically, the trader would be notified of the opportunity, who will then decide whether to place the trade.
There are a range of traders who, instead of operating their own software systems, rely on what is regarded as the "remote alert service". Access to such service allows them to receive an automatic trading opportunity notifications in the same manner as they would integrating their own software programs. The difference here is that alert signals are given by software running at another location, outside the trader's own network or computer which may expose privacy concerns and can lead to significant delays.
Is arbitrage trading illegal?
Crypto arbitrage is completely legal as the only thing that is being done is exploiting price gaps between exchanges. A person conducting arbitrage is just buying and selling as any other trader would do.
How to profit from crypto arbitrage strategy?
As a retail trader, you may notice that coming across brokers suitable for crypto arbitrage is a bit uneasy task. In order to gain consistent profits with this strategy, it is recommended to find a good combination of a Fast Price Feed Provider (Fast Broker) and a Slow Trading Broker offering leveraged trading on crypto assets. By using arbitrage expert advisor the account performance will depend on the Internet speed, geographical location of your PC system and the hardware on which MetaTrader terminal is run. The smaller the ping to the Fast Price Feed Provider (Fast Broker) and the greater the Ping to the Slow Broker, the better the performance of the Expert Advisor used for arbitrage will be.
Overall, cryptocurrency arbitrage may be an opportunity to make some passive income, but at the same time it involves risks. The forex market is considered the largest financial market globally. Trading in pairs is one of the most common strategies some traders may shy away during times of volatility. Thankfully, specific strategies, such as high-frequency trading, can help whether such conditions and, at the same time, help close market gaps and increase their efficiency.
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