How does arbitrage work on the cryptocurrency market?

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How does arbitrage work on the cryptocurrency market?

The main types of earning on cryptocurrency are mining and trading. Mining requires constant control. Over time, equipment becomes outdated and impaired and needs modernization. Trading looks more attractive. Cryptocurrencies are volatile, so you don’t need a large amount to start trading (in contrast to the other markets). However, stock trading requires certain knowledge and experience and entails risks. Fortunately, cryptocurrency arbitrage allows you to work with minimal risk without possessing special skills.

The principle of strategy

The principle of arbitrage in the cryptocurrency market is limited to the concept of all exchange trading — “buy cheap and sell high.” In this case, the trader doesn’t have to predict the movement of the rates and wait for the perfect moment to buy/sell. All transactions are made simultaneously. You buy digital currency cheaper at one place and sell high in another. There are intra-exchange arbitrage and arbitrage between the exchanges. In the first case, the trader acts as an intermediary between the buyer and the seller and pocket the difference. In the case of inter-exchange arbitrage of cryptocurrencies, the trader uses the exchange rate difference on different platforms. What’s the reason for such a distinction? The cryptocurrency market is young and decentralized. There is no single central platform; exchanges operate using slow web technologies, so rates will vary as long as there are delays in communication channels.

Territorial reason

Exchanges differ in terms of withdrawal conditions. There are platforms from which you can withdraw funds only to the accounts of certain banks in certain countries. Restrictions on deposit/withdrawal of funds and high fees lead to a decrease in demand for cryptocurrency and the emergence of price extensions. The cryptocurrency market is still small, and some players can influence it by carrying out large transactions.

Arbitration strategy for cryptocurrency leads to the inevitable enrichment at high speed. But it all comes down to the commissions, as they eat up the trader’s profit. When calculating the commission, consider the transaction in the exchange, and charges for deposit/withdrawal from the platform itself. Intra-exchange arbitration is particularly common. It is easier to implement and doesn’t require payment of fees for deposit/withdrawal of funds from the platform. There are many types of strategy: statistical, synthetic, temporary, etc.

Statistical arbitrage

It is well known that rates at different sites are not equal but intercorrelated. The growth of cryptocurrency rate on one exchange will inevitably lead to its growth on the other. However, due to the youth of the market and the imperfection of the infrastructure we talked about, these changes will not happen immediately. As a result, the trader has accurate information about the upcoming rate movement. This arbitration scheme (unlike the classical one) contains additional risk. The risk lies in the absence of guarantees that the course will behave exactly as on the other site. This risk is not critical, and in most cases, the scenario repeats itself. Not for nothing, this phenomenon is identified as a pattern. The method can be used both when working with one currency on different exchanges and when working with different coins on the same platform.

An example is the relationship between bitcoin and litecoin. If you place their quotes on the chart, you can identify good moments for transactions, when gaps are formed between prices. People usually buy the cryptocurrency that plunged in value given that that the other one went up.

How does the strategy work in practice?

First of all, you need to create a so-called “trading portfolio.” Select several instruments. Then determine which of the tools selected is underestimated right now, and which, on the contrary, is overvalued. Behavioural analysis of the asset for a certain time will help you accomplish that. Correct conclusions will allow you to sell or buy an asset profitably.

Let’s look at the example. Most often, this statistical strategy is used to arbitrage bitcoin and litecoin pairs. The correlation between these currencies is high. Periodically, bitcoin and litecoin change places: one currency grows in price, while the other falls. You should study the behaviour of the currency, then sell the leading coin and buy the catch-up one. Close the deal only at the time of their contact.

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