Will the traveling salesman’s economy work in this modern age? Can you still do it with crypto arbitrage?
If you’ve stumbled across a game where you can buy weapons in one place for cheap and sell them in another place for profit, congratulations! You’ve just made an arbitrage trade!
Although the market might seem consistent, there are still some inefficiencies that can be exploited through this method to make a quick buck here and there. Through the dangerous murky waters of the crypto economy, is there still really a way to make money aside from relying on market volatility?
Our guide is designed to walk you through crypto arbitrage, its risks, and a thorough explanation of how it works.
What is Crypto Arbitrage?
Crypto arbitrage is essentially the practice of taking advantage of market inefficiencies to buy assets from one platform in order to sell them for profit elsewhere. This method takes advantage of the broad number of crypto markets by spotting differences in prices and using them to your advantage.
For instance, if BTC is priced at $20K on Binance but $20.2K on Coinbase, you can make roughly $200 in profit if you buy and sell 1 BTC.
What do you consider when buying crypto? Aside from security, have you ever considered if you are really getting the best price for your purchase?
Arbitrage can be layered with single assets or asset pairing to help you come up with the best deals and profits in between. Essentially, crypto arbitrage means buying crypto from one platform at a cheaper price and selling the same crypto at another platform to make a profit.
How Crypto Arbitrage Makes Money (In-Theory)
Professionals in this space usually make use of crypto arbitrage signals or a crypto arbitrage bot to spot inefficiencies or execute trades on their behalf to make a profit in between. There are many forms of crypto arbitrage and even more arbitrage techniques that you can use in order to carry out better executions.
Although in a perfect world everything would be easy to arbitrage, there are many factors that could affect your profitability or loss depending on market conditions. These conditions involve the volatility of prices, transaction fees, and the amount of liquidity in a liquidity pool, which can affect price slippage.
Crypto Arbitrage Layers
The crypto arbitrage can be carried out through a singular asset or pairs of different assets to come up with a profit by exploiting inefficiencies in between. Let’s explore the different layers you can follow.
Single Layered Arbitrage
Single-layered arbitrage revolves around one asset or one crypto being traded from one platform to another. Let’s say you have to pay 1 USDT for the imaginary crypto $IMAGINARY in platform A and sell it for $1.20 USDT in platform B.
This is the simplest form of arbitrage that involves a single transaction to purchase and a single transaction to sell. Crypto arbitrage can be tiered differently with more difficult computations per tier. With every tier, crypto arbitrage also becomes riskier due to volatility and slippage.
Double Layered Arbitrage
Double-layered arbitrage or dual-layered arbitrage involves purchasing crypto to have access to a pair with cheaper prices that can be sold elsewhere for higher prices. Sounds confusing? Let’s break it down.
Let’s say you’ve spotted inefficiencies in the fictional $IMAGINARY-$PRETEND token pairing. When looking at the market, it appears that in platform A, you only need 1 $IMAGINARY to buy 2 $PRETEND but in platform B, you need 1.5 $IMAGINARY to buy 2 $PRETEND. If you buy $IMAGINARY for $1 on platform A and trade it for 2 $PRETEND, you can then sell your 2 $PRETEND to get $1.5 per $IMAGINARY on platform B.
Although it gets a bit more complicated, these types of crypto arbitrages are more common compared to single-layered arbitrage. With that being said, it also comes with greater risk because you also have to factor in more transaction fees.
Triple Layered Arbitrage
Triple-layered arbitrage involves buying a cryptocurrency, buying from a pair, buying from another pair, and then selling the crypto at a higher price. Basically, this is just a double-layered arbitrage with more steps.
Due to market inefficiencies, not all cryptocurrencies can be bought with every type of pair, which is why you can perform arbitrage in order to earn just by moving crypto around.
For example, let’s say that the pairs for the fictional cryptos $JOKE-$EXAMPLE are way too inefficient and charge a lot. Let’s say you need 2 $JOKE to buy 1 $EXAMPLE on platform C. You’ve seen that 1 $EXAMPLE can be sold on platform B for $6 and the price of 2 $JOKE is just $2 on platform B, but the problem is that there is no way to buy $JOKE except on platform A with the $IMAGINARY-JOKE pairing and 2 $IMAGINARY gives you 1 $JOKE.
Let’s say the price of $IMAGINARY is at $1 each so you spend $4 to purchase 4 $IMAGINARY and swap that $IMAGINARY for 2 $JOKE on platform A. You then head over to platform B to swap your 2 $JOKE for 1 $EXAMPLE. After that, you take your $EXAMPLE token and sell it on platform C for $6. You’ve spent $4 in total but were able to go home with $6 in this scenario just by shifting things around.
In this example, however, you’ll have to account for transaction fees, slippage, and fluctuating costs so more realistically, this scenario would bring the total end amount to about $5.
Stablecoins can be used to perform more simple forms of arbitrage across different platforms. Let’s say you spot $IMAGINARY for just $1 USDT each on platform A but on platform B, if you sell it for $USDC, you’ll get $1.20 $USDT for each $IMAGINARY.
The prices of different assets fluctuate depending on the liquidity pool on each platform. If an asset has less liquidity, the price becomes higher but if an asset has more liquidity, the prices can drop down and this is where slippage goes in.
Most platforms use an automated market maker system wherein buyers place in the price they want to buy X amount of crypto and sellers place a price they want to sell X amount of crypto. When prices are matched, a transaction goes through but what if they do not cover the X amount of crypto that the buyer wants to purchase?
This is where slippage comes in. Slippage refers to your tolerance when it comes to price fluctuations meaning you’re still okay buying if the price goes higher by a certain percentage. Say you place 5% as your slippage, this means you’ll be able to purchase the particular crypto at 5% higher than your bidding price.
The problem with not using slippage is that some platforms won’t carry out your transactions. Despite not carrying out transactions, some platforms will still require a fee just to place out the details of the transactions which is another thing you want to factor in when performing crypto arbitrage.
Ideally, you’d want to use the least amount of slippage possible to make the most out of your transaction.
Making use of fiat currencies on centralized platforms is another way for you to earn but this process can be extremely risky. Some platforms won’t allow you to utilize assets that are past the two-decimal point meaning if you have $1.001 USD, you will have lost that $0.001 forever, and although this sounds like a small amount, these inefficiencies can add up, especially if you are performing small scale arbitrage.
Let’s say hypothetically the price of the EU pound and the price of USD are the same for this example and the price of the fictional cryptocurrency $IMAGINARY is $1 in USD and $1.20 in Euro. If you buy 5 $IMAGINARY in USD, you will pay $5 each but if you sell your $IMAGINARY in Euro, you will earn $6 in that currency.
You can then repeat this process and now, purchase 6 $IMAGINARY in USD and sell it for $6.20 worth in Euro which you can exchange for USD and repeat the process over and over. Due to lower fees and no slippage on centralized exchanges, this method is easier and safer but it does come with a big warning that the pair could disappear and you might be left with a loss trying to sell your crypto back for the same or another currency.
What are the Risks?
Like everything DeFi, crypto arbitrage comes with a big risk factor. One of the largest reasons why not a lot of people are doing this is because of the complexity and time it takes to research just to find the perfect crypto arbitrage pair or pairs.
As mentioned earlier, although platforms charge a small fee, these fees add up. This is why most crypto arbitrage traders often perform these types of trades with a significant investment. The problem with small arbitrage trades is that if your profits or the difference are minimal, you’ll have to go through a complicated process for just a small amount of profit. As you’ve seen above, crypto arbitrage is complicated and does take time to execute.
Market volatility plays a huge factor when looking for crypto arbitrage pairs. If crypto is highly volatile, its price could drop from the time you bought it to the time you sell it causing you to incur a loss. This is why most professional traders use a crypto arbitrage trading platform that has access to stablecoins or fiat currency.
If one pair is less prone to volatility, the better. Although the ideal way to make the most money in the safest way possible is two cryptos with almost zero fluctuations, this is something highly impossible except with stablecoins.
Even with stablecoins, however, there still remains a huge risk of something bad happening. If you’ve followed what happened to LUNA’s UST, this could be a strong reminder to do your own research (DYOR) even when it comes to stablecoins.
Unlike yield farming on DeFi where you have to wait a certain period to get the most out of your annual percentage yield (APY), crypto arbitrage earnings and losses will reflect instantly. Although the process of performing arbitrage is time-consuming, the end results can be felt almost instantly. Due to how much time it takes to perform arbitrage, professional traders will use a crypto arbitrage bot to carry out their automatic trades or automate their trades.
Once an exploit can be found and stays inefficient for a while, traders can utilize this gap to make money with arbitrage. Not everything lasts, however, and the more arbitrage is done within these inefficiencies, the smaller the gap becomes.
It is important to perform a crypto arbitrage trade only when it is profitable or the profit is significant enough to ensure that you don’t waste your time while placing yourself in a vulnerable situation where the risk of loss is greater.
The problem with most popular cryptos is that their pairings and offerings are often more efficient than others. With lower market cap or low-popularity cryptos, however, although the potential might be large, due to liquidity, the slippage might be too high.
When performing crypto arbitrage, it is important that your slippage does not exceed the percentage of what you will be selling it for. If you are estimating $10 in profit, it is important that the slippage will not exceed $8 in percentage.
Aside from the price and slippage, you also have to account for transaction fees as an automatic additional expense especially if you are moving assets from one platform to another.
Crypto arbitrage usually makes use of the lack of liquidity for a certain pool or pair. When liquidity suddenly comes in, this could jeopardize your entire crypto arbitrage altogether. Sudden liquidity coming in usually corrects inefficiencies leaving no room for traders to perform arbitrage.
The problem with sudden liquidity is if it comes in while you are in the process of doing crypto arbitrage, this can result in a significant loss while you are in between transactions.
One thing you have to understand about performing crypto arbitrage on centralized exchanges is that it can be hard to transfer outside of the exchange to a crypto wallet without incurring significant fees. When performing crypto exchange on centralized exchanges, it is recommended that you stay on those exchanges instead of trying to shift the assets from one exchange to another unless your arbitrage profit is significant enough for you to go through these multi-layered arbitrage transactions.
When performing crypto arbitrage, it is important to do this on a singular blockchain instead of bridging your assets from one blockchain to another. Bridging can not only be expensive, but this can also ruin your arbitrage strategy as a whole.
When performing crypto arbitrage, make sure to look for inconsistencies within the blockchain itself instead of from one blockchain to another (unless this is the purpose of your arbitrage).
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