Last week we discussed the hot topic of High Frequency Trading. Today we will explore another facet of automatic trading, that of arbitrage.
What is arbitrage, its different forms and is it possible in the crypto market? Don't worry we'll answer all these questions today!
What is arbitrage?
Arbitrage is the technique of purchasing an asset, selling it right away, and profiting from the price discrepancy. Depending on the price difference it brings, the asset will typically be sold in a different market, in a different form, or using a different financial instrument. Almost every financial item, including stocks, currency, commodities, derivatives, and of course, cryptocurrencies, has the potential to offer arbitrage possibilities.
In the case of stocks, for instance, arbitrage can happen when a stock is listed on markets in two separate nations. The price of the stock differs from one exchange to another as a result of the divergent exchange rates for each nation. As a result, an investor might make money by buying and selling stocks on several exchanges at the same time by taking advantage of the price difference. It works the same way for cryptos and the different trading platforms.
When there is a disparity between three currencies and their exchange rates are not equal, triangular arbitrage is a buying and selling transaction. When the cross rates of the three currencies do not coincide, gains might be realized from this disparity. by doing three simultaneous transactions in which one currency is bought, another is sold, and a third is used as the base currency.
An illustration of triangle arbitrage in the crypto market is given below:
In the scenario that follows, we begin with a BTC investment. We finish with BTC after executing all three trades. The following transactions will be made:
1 - Buy Binance Coin (BNB) with Bitcoin (BTC)
2 - Buy Tether (USDT) with Binance Coin (BNB)
3 - Sell Tether (USDT) for Bitcoin (BTC)
We may compare the final Bitcoin value with the initial investment we made at the beginning of step 1 after the third transaction. All three transactions can be started at once to generate a profit if this results in a sizable profit.
Arbitrage in the classical markets requires resources and access to information that most non-institutional players cannot afford. On the crypto market, the practice is already professional but the lack of maturity of the market allows non-institutions with sufficient knowledge to code such an algorithm to take advantage of it, for the moment.
Next week we'll talk about more traditional trading algorithms, how they work and how to create one!