Arbitrage trading can be defined in a fairly simple way - purchasing an asset or commodity for one price and selling it for a different price profiting on that difference. For example, if a trader buys $5 worth of coin on one exchange, and then sells it for $10 on another exchange, he is making 100% profit fast and with low risks. This is a simple example of spatial arbitrage. However, if you dive deeper into the topic of arbitrage trading, more complicated definitions start to emerge.
This strategy involves the exchange of a currency for a second, then the second one for a third and then back to the original currency in a short amount of time. Profiting from this strategy requires a fast reaction to market fluctuations and the opportunity to perform transactions at a low cost.
For both simple and complex arbitrage strategies, market discrepancy has to occur in order to make any profit. However, arbitrage trading actually helps to stabilize asset’s price across different exchanges. When an asset has a low price on one exchange, demand will increase, thus, increasing its price, and then selling it to another exchange with higher price will lower it. This is how prices become roughly the same.
Without market fluctuation, there would be no arbitrage opportunities that could generate profit. This is how the more arbitrage trading is implemented, the less opportunity for it remains.
Because the market has a tendency to stabilize itself, there are not too many arbitrage opportunities presenting itself in the first place. There may be discrepancies due to geographical location and difference in jurisdiction due to political and economical events specific to that particular location.
For example, during the peak of bitcoin market in 2017, there were regularly higher prices for cryptocurrencies in South Korea driven by strong local demand. This price differential was referred to as the “kimchi premium”. A paper from the University of Calgary identifies two main causes of the premium: capital controls and friction caused by the Bitcoin network itself (transaction speed and fees).
However, it is almost impossible to predict this type of opportunity arising because so many conditions have to be in place in order for it to occur. This is why an average trade will not be able to take advantage of these conditions and generate a profit in time.
So how is arbitrage strategy executed? It is the difference between the higher price and the lower price that creates a spread. The higher the spread value, the more profit can be made from a trade. To be able to react quickly considering the spread value in the moment, it is necessary to hold a substantial sum of both assets.
This is why most arbitrage trading is being carried out by hedge funds and “whales” - the sheer size of the orders that they are able to place creates an advantage in a volatile market.
As an individual investor, it is rather difficult to employ arbitrage trading. It takes a lot of time and effort to analyze different exchanges and their prices, find discrepancies in the market and act on them.
This is why many small investors utilize trading bots and specifically designed scripts. Most of the popular exchanges such as Binance, HitBTC and Bitfinex have an API which can become a useful arbitrage tool.
Some of these exchanges allow you to create a custom trading bot so you do not have to execute orders manually. However, paying close attention to any opportunities that may arise is still beneficial for an individual trader.
Because arbitrage strategy requires a significant amount of funds and sophisticated trading tools, it is mostly exercised by large and institutional investors.
A small investor with limited funds will face difficulty having enough assets to trade quickly on different exchanges as well as having enough technical knowledge to execute these trades in a timely manner.
Additional costs such as deposit, withdrawal and trading fees also eat up a good chunk of the profit. Therefore, the potential risks have to be considered in comparison to potential profit in order to successfully employ arbitrage trading strategy.