BLOG | September 26, 2017

An Introduction to Arbitrage Trading

What is Arbitrage trading

Arbitrage trading is a style of trading that seeks to eliminate the vast majority of market risk, ensuring a win on every trade. As markets like forex and cryptocurrency are decentralized, price discrepancies often exist between two brokers or exchanges. Arbitrage traders seek to capitalize on these price discrepancies, simultaneously buying and selling the same instrument at two different exchanges or brokers.

The idea is to sell at the broker or exchange with the higher price and buy at the broker or exchange with the lower price. Once the market moves, you will have one profitable trade and one losing trade, but as you bought low and sold high, your winning trade should be slightly larger than your losing trade, which means you can close both positions for a net profit.

A Word of Warning

Though arbitrage trading eliminates the vast majority of market risk, it does introduce a new element of risk: lots of brokers do not allow arbitrage trading and you can have your account closed or even have your profits confiscated if you do not pick your brokers wisely.

The brokers you select should advertise that they allow all trading strategies, this is generally true-ECN and STP brokers. These brokers are generally a good idea anyway, as the fees are much lower and whatever price discrepancy you seek to capitalize on will need to exceed trading fees at both brokers or exchanges (spread + commission).

An example of a Bitcoin arbitrage trade
Though the forex market is decentralized, it is also incredibly liquid and efficient, which means large arbitrage opportunities are quite rare. Cryptocurrency markets on the other hand are still very young and arbitrage opportunities abound between different brokers and exchanges.

In this example we will be exploiting a hypothetical price discrepancy between a Bitcoin exchange that offers margin trading and a traditional forex and CFD broker that offers a Bitcoin contract.

  • The bitcoin exchange is quoting a bid of $4750 on BTCUSD
  • The traditional forex/CFD broker is quoting an ask of $4710 on their BTCUSD contract
  • Trader sells 10 BTC on exchange at $4750 and buys 10 contracts at the CFD broker at 4710
  • Some negative news comes out of China which sends Bitcoin to $4600 at the exchange and the broker
  • The short position at the Bitcoin exchange is now in profit by $1500
  • The long position at the forex/CFD broker is now down $1100
  • Our trader closes both positions and turns a $400 profit with minimal risk

Even if the news out of China had been good and Bitcoin had rallied to 4900 at both venues, our trader still would have turned a profit. Our traders long position would have been in profit by $1900 and the short position would have been down $1500, by closing both trades, our trader still turns a profit of $400 with minimal risk.

Note that the above example was formulated with simplicity in mind, in reality you would not really have to wait for a big news event or market movement – price discrepancies develop and dissipate throughout the trading day, even in quiet markets and consolidation.

Almost Risk-Free

Arbitrage trading eliminates the vast majority of market risk as you are buying and selling the same asset simultaneously at an advantageous price. If you miss an opportunity to cash out at a profit and another discrepancy forms, you simply wait til this new discrepancy dissipates and cash out (you could even trade the second discrepancy too). Having said all that, this approach to trading does not eliminate market risk entirely and you do need to do some research before just leaping in blindly.

For example, some exchanges will always trade at a premium or discount vs others for one reason or another. What you think is an inefficiency could actually be efficient markets in action. An example of this from history is traders trying to capitalize on the discrepancy between Mt Gox Bitcoin and the Bitcoin price at the rest of the exchanges. This “inefficiency” never resolved itself, there were serious problems at Mt Gox and that’s why the price was cheap. Anyone who bought there seeing an arbitrage opportunity simply lost money when the exchange folded.

As such, you should only trade with two exchanges that usually mimic each other quite closely and ensure you are trading a genuine inefficiency and not some problem with the broker/exchange.

Give it a Go on a Demo

The best way to learn the ins and outs of arbitrage trading is by signing up for demo accounts at two different CFD brokers. Most cryptocurrency exchanges don’t allow paper trading, so this is why the forex guys are probably a better option while you are learning the ropes. Set the same deposit and trade a fixed lot size at each broker. Remember any discrepancies you seek to exploit will need to be larger than round turn transaction fees at both brokers … have fun!

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An Introduction to Arbitrage Trading
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An Introduction to Arbitrage Trading
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Arbitrage trading is a style of trading that seeks to eliminate the vast majority of market risk, ensuring a win on every trade. With arbitrage trading the idea is to sell at the higher price and buy at the lower price. Once the market moves, you will have one profitable trade and one losing trade, but as you bought low and sold high, your winning trade should be slightly larger than your losing trade, which means you can close both positions for a net profit.
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ForexTips
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