Crypto arbitrage: How it works & trading strategies

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Cryptocurrency arbitrage is a strategy in which investors buy crypto on one exchange and then quickly sell it on another exchange for a higher price.

Because any given cryptocurrency might trade at different prices on different exchanges, it’s an opportunity that many investors have seized in recent years.

Related: Different types of crypto airdrops and how to find them

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How Does Crypto Arbitrage Work?

Crypto arbitrage: How it works & trading strategies

Arbitrage as an investment exists across the capital markets, in stocks, bonds and commodities, wherever the same asset trades for different prices in different places.

Since cryptocurrencies are completely digital and aren’t based on an underlying asset, it is harder to place a value upon and doesn’t have the same pricing conventions as equities and bonds, which are tied to the performance of a company, municipality or nation.

Since cryptocurrency prices can vary from exchange to exchange, arbitrage opportunities abound, with more than 5,000 cryptocurrencies trading on more than 200 exchanges for people investing in cryptocurrency.

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Crypto Exchanges

Crypto arbitrage: How it works & trading strategies

The crypto exchanges all work similarly, pricing crypto based on the last trade on that exchange. But it’s important to note that not all exchanges are created equal. Some of them have enormous trading volumes, while others aren’t as active. The trading volume on each affects the liquidity and the available prices on a given exchange.

Because there are so many cryptocurrency exchanges, an investor can spend a lot of time tracking crypto prices in real time, to pinpoint opportunities for crypto arbitrage. There are a number of apps investors can download that will track the prices of Bitcoin and other cryptocurrencies for arbitrage opportunities.

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How Can You Make Money With Cryptocurrency Arbitrage?

Crypto arbitrage: How it works & trading strategies

At first glance, cryptocurrency arbitrage seems like a simple matter of looking for gaps between the prices on one exchange and another, and then executing a buy and a sell.

Famously, in 2017 there was a moment when the price of Bitcoin on Kraken was $17,212, but only $16,979 on Bitstamp—presenting an arbitrage opportunity. In that instance, an investor could potentially make $233 per Bitcoin by buying them on Bitstamp, and then quickly selling them on Kraken.

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Price discrepancies

Crypto arbitrage: How it works & trading strategies

While Bitcoin spreads aren’t always as wide as in the above example, there are times when other, less well-known forms of crypto could offer even wider gaps from exchange to exchange.

Taking advantage of those price discrepancies is what crypto arbitrage is all about. And it offers opportunities to make quick profits for traders who are willing to research the many forms of crypto as well as the exchanges they trade on, and then track the price fluctuations of those currencies in real time to find the price discrepancies. But there’s more to crypto arbitrage than just exploiting the price spreads among different exchanges.

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Calculating Cost vs. Profit with Crypto Arbitrage

Crypto arbitrage: How it works & trading strategies

To build on the 2017 example above, if an investor at that time wanted to make enough money to justify their time and effort spent researching this complex trade — say, a profit of $2,330 — they would have had to put almost $170,000 at risk.

If they wanted to make $23,000, they would have to put $1.7 million in liquid capital into play. Having that much capital ready and waiting to deploy comes with an opportunity risk.

To succeed in crypto arbitrage, investors need to execute the trades quickly in order to take advantage of cryptocurrency price differences from exchange to exchange, while those differences are still profitable.

With the thinly traded forms of crypto that offer the widest spreads, a trader has to be careful not to increase the purchase price and decrease the sale price of a digital asset by their own trades.

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Transaction Fees

Crypto arbitrage: How it works & trading strategies

At the same time, traders need to keep an eye on the transaction fees that come with buying and selling across trading platforms. As the cryptocurrency markets evolve, these fees continue to fluctuate, varying from exchange to exchange.

The exchanges themselves can also come with risks. One reason that a given exchange may offer such an appealing buy or sell price is that the trading volume on it is very low.

And low volume may mean that the exchange can’t execute a trade large enough to deliver the profit an investor is hoping for. Low volume may also mean that the trade is possible but will take too long to seize the pricing opportunity.

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Where to Look for Arbitrage Opportunities

Crypto arbitrage: How it works & trading strategies

Not every cryptocurrency digital asset is created equal when it comes to arbitrage. For instance, Bitcoin has become very widely traded, with trading volume growing from an average of $5-$10 million per day in 2017 to $100-$200 million per day. That’s resulted in fewer Bitcoin arbitrage opportunities. But there are other ways to get involved in crypto arbitrage besides investing in bitcoin.

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1. Target less-popular cryptocurrencies

Crypto arbitrage: How it works & trading strategies

Investors can find bigger price spreads for the same cryptocurrency digital assets among less-popular, less-frequently traded forms of crypto (Ripple, Stellar, and IOTA are a few other forms).

Because they’re less popular, though, these cryptocurrencies are prone to rapid price fluctuations. That volatility can be good or bad news, but it adds another level of risk to an arbitrage strategy.

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2. Take advantage of new software

Crypto arbitrage: How it works & trading strategies

With so many different cryptocurrencies on so many exchanges, finding those opportunities is a daunting task. That’s why many traders use software applications that track the hundreds of cryptocurrency exchanges in real time.

There are a growing number of companies that specialize in software to automate crypto arbitrage. One such company, ArbiSmart, has a tool that allows investors to choose an automated arbitrage strategy and execute it across different exchanges.

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3. Explore “triangular arbitrage”

Crypto arbitrage: How it works & trading strategies

This strategy takes advantage of pricing inefficiencies among cryptocurrencies on the same exchange, or across exchanges. Put simply, with this strategy an investor starts with one cryptocurrency and then trades it for another cryptocurrency on that same exchange — one which is undervalued relative to the first crypto.

The investor would then trade that second cryptocurrency for a third cryptocurrency which is relatively overvalued when compared with the first. Finally, the investor would trade that third cryptocurrency for the first crypto, completing the circuit a little richer.

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Is Cryptocurrency Arbitrage Legal?

Crypto arbitrage: How it works & trading strategies

Cryptocurrency arbitrage is legal, as is arbitrage in most other financial assets. While it may seem like an investment that offers money for nothing, arbitrage actually plays an important role in creating efficient markets and setting clear prices for market participants by making sure the same asset trades at the same price across exchanges.

Cryptocurrencies are largely unregulated, which is one of the key things to know before investing in cryptocurrency. As a result, they come with more risks from hacks, fraud, and outright currency collapse. (That’s why securely storing your cryptocurrencies is a hot topic among investors.)

In the United States, where cryptocurrency adoption has skyrocketed in recent years, the IRS has created a tax guide which categorizes cryptocurrencies as property. The Securities and Exchange Commission, on the other hand, has called cryptocurrencies a form of security — and the Commodity Futures Trading Commission has called them a form of commodity.

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Cryptocurrency Arbitrage and Taxes

Crypto arbitrage: How it works & trading strategies

The IRS treats cryptocurrency gains in the same way as gains made from selling property. With that in mind, investors must account for any capital gains or losses on their Federal income tax return, and may also be able to take deductions based on any losses, as outlined in Publication 544, Sales and Other Dispositions of Assets.

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The Takeaway

Crypto arbitrage: How it works & trading strategies

Cryptocurrency is complicated, and arbitrage strategies can be even more complex. But the practice is legal, and has the potential to yield high rewards while also exposing an investor to high risk.

As with any investment strategy, it is important for investors to do their own research when exploring crypto arbitrage, including looking at different, lesser-known cryptocurrencies, and available software to track cryptocurrency exchanges in real time.

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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.

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