Understanding Arbitrage
Arbitrage is a trading strategy that takes advantage of market price differences, such as stock and cryptocurrency exchanges. These markets are inherently inefficient due to various factors, including variations in access to information, trading tools, transaction costs, and human psychology.
Arbitrage traders capitalize on these inefficiencies by quickly purchasing an asset from a market priced lower and selling it in a market where it commands a higher price. This strategy helps narrow the price disparity, known as the “spread,” between different exchanges, ultimately making the markets more efficient.
The primary reason arbitrage exists is due to market inefficiencies. By participating in arbitrage, traders contribute to the efficiency of markets, ensuring that the same asset is priced similarly across various exchanges. This process prevents assets from deviating significantly from their fair value and promotes the smooth flow of liquidity between exchanges.
While arbitrage entails buying and selling the same quantity on different exchanges, it involves minimal price risk for the trader. However, there are still risks associated with executing arbitrage strategies. These risks arise from the need for near-instantaneous trades and the costs involved in trading, such as commissions. Arbitrageurs often incur substantial commission fees since they must pay for each trade conducted on different exchanges.
Arbitrage example
Arbitrage trades can occur between two or more markets involving one or more assets. For instance, a simple arbitrage trade could involve buying Bitcoin (BTC) at $19,975 per coin on exchange A and selling it for $19,987 on exchange B. More complex trades, like triangular arbitrage, involve buying and selling three different assets across three different markets.
The advancement of technologies, particularly automated trading, has expedited the elimination of arbitrage opportunities, making it more challenging for traders to practice. However, as long as markets remain imperfectly efficient, arbitrage will continue to serve its crucial role.