The crypto market is still emerging, and there are many opportunities to make money, from play-to-earn crypto games to crypto arbitrage trading in DeFi (decentralized finance).
Arbitrage trade represents a compelling financial opportunity, and it is particularly attractive because of its great risk-to-reward ratio. However, you shouldn't think it's all a breeze and that anyone with minimum trading strategy knowledge can do it. DeFi arbitrage requires strong technical skills and outstanding market knowledge. The risks involved might be low, but that doesn't mean they don't exist.
Let's study together how to execute arbitrage trades and understand both the arbitrage opportunities in DeFi and the possible risks.
What is arbitrage trade?
Crypto arbitrage is a trading strategy where arbitrage traders and crypto investors profit from the price differences of crypto assets across multiple markets or different exchanges.
If you look on Investopedia, you will see arbitrage is defined as "the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset's listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms."
Simply put, you could buy a digital asset from a decentralized exchange and sell the same asset for a higher price on another platform, profiting from the price discrepancy.
Cryptocurrency arbitrage in DeFi
When it comes to DeFi arbitrage, the idea is similar. Arbitrage traders search through liquidity pools to find assets that don't have the same price as the average market value. They buy these assets at a lower price, driving the demand upwards, and then they sell the same assets on decentralized exchanges.
How Does Arbitrage Work in DeFi?
DeFi arbitrage makes use of the fact that different protocols charge various prices for the same asset. Let's imagine that you have the money available to purchase 1 ETH. Assuming the price of ETH on Binance is $1,000 and the cost of ETH on Nexo is $1,050, then a $50 profit can be made if you purchase Ethereum on Binance and sell it right away on Nexo.
The fact that the two protocols charge different prices for the same cryptocurrency creates this arbitrage opportunity. Needless to say, you can only take advantage of such an opportunity if you manage to immediately sell the Ethereum network token from one protocol to another with minimal transaction fees.
Transferring Crypto Between Exchanges
Let's remember swiftly what decentralized exchanges are. A decentralized exchange is a protocol that allows you to trade assets without having to trust a centralized third party. All the trades are executed by smart contracts on the blockchain.
This means you can move your ETH from one decentralized exchange to another pretty fast and without fees, making them perfect for arbitrage trading.
There are many different exchanges, each with its own advantages and disadvantages. Some of the most popular decentralized exchanges where you can buy or sell assets include 0x Protocol, Kyber Network, Bancor Network, and AirSwap.
Arbitraging between DEXs is one of the best trading strategies to increase your investment's return without taking on any risk because there are so many different DEXs to select from, and they rarely offer identical asset prices for the same tokens.
Types of crypto arbitrage strategies
There are several arbitrage methods that can help traders to make a risk-free profit. Let's take a closer look at them:
The cross-exchange arbitrage is the most popular type of arbitrage trade as it's the easiest one to do. Arbitrage traders try to generate profit by buying crypto on one exchange and selling it on another exchange with the help of cross-exchange transactions.
Arbitrage opportunities like this one exist because you can find an asset listed with disparate prices on several exchanges.
This is an additional type of cross-exchange trade. The exchanges' various geographic locations are the only distinction. The spatial arbitrage strategy could be used to profit from the disparity between the supply and demand for Bitcoin in America and South Korea.
The triangular arbitrage is a process that involves moving funds between three or more digital assets on a single decentralized or centralized exchange in an effort to profit from the difference in asset prices between one or two cryptocurrencies. A trader could, for instance, establish a trading loop that begins and finishes with BTC.
For example, traders might change Bitcoin for ETH, then exchange ETH for Cardano's ADA token, and finally change ADA back to BTC. They switched between three cryptocurrency trading pairs: BTC/ETH, ETH/ADA, and ADA/BTC. The traders will end up with more Bitcoin than they had at the beginning of the trade if there are differences in the prices of any of the three crypto trading pairs.
As long as all transactions are executed on the same exchange, the traders don't need to deposit or withdraw their funds from multiple exchanges, saving money by having fewer gas costs ( as you remember, the gas price is the cost necessary to perform a transaction on the Ethereum network.) A higher gas price could make you lose money when trading.
Market making is another type of arbitrage that has to do with providing liquidity to a market. In return for the liquidity they provide, market makers are rewarded with a small portion of each trade that gets executed on the market.
Investors can successfully reduce the spread and raise market efficiency by supplying liquidity to the market. However, it's important to note that having a thorough understanding of the market one trades in, and the ability to act promptly are prerequisites for effective market-making.
Decentralized arbitrage works on decentralized exchanges or AMMs ( automated market makers), which use automated and decentralized programs known as smart contracts to determine the price of crypto trading pairs.
Arbitrage traders can intervene and carry out cross-exchange trades between the decentralized exchange and a centralized one if the prices of crypto trading pairs are dissimilar from their spot prices on centralized exchanges.
This method combines econometric, statistical, and computational techniques, making money by executing arbitrage trades at scale. To carry out high-frequency arbitrage trades and maximize profit, traders who employ this strategy rely on statistical models and trading bots. Trading bots are automated trading tools that quickly and efficiently carry out many deals using pre-established trading strategies.
Why is crypto arbitrage considered a low-risk strategy?
Unlike day traders, crypto arbitrage traders do not need to forecast future Bitcoin prices or place deals that could take hours or days before they start making money.
Traders make decisions based on anticipating they will make a fixed profit by finding arbitrage opportunities and taking advantage of them, rather than necessarily evaluating market sentiments or relying on other predictive pricing methodologies.
Furthermore, depending on the resources available to traders, an arbitrage trade can be entered and exited in seconds or minutes.
As such, we can see why this trading method carries fewer risks. Traders are substantially less exposed to trading risk because they need to execute trades that last a few minutes at most and don't usually use predictive analysis.
However, there are certain risks that you should be aware of.
Risks Associated With Arbitrage in DeFi
As we already established, the risks are far lower but not non-existent. Let's take a look:
Trading on decentralized exchanges involves placing your trust in the other party to carry out their end of the bargain. Without the involvement of a third party to regulate the transactions, like in traditional markets, there is an inherent risk that the other trader won't fulfill their side of the trade. If that happens, you risk losing your profit.
Another risk that you can encounter trading on a DEX involves the lack of liquidity in the market, which could affect your order. If there isn't enough liquidity on the market to fulfill your order, you could end up being stuck with an asset you can't sell.
As you should know by now, crypto assets are quite volatile, seeing considerable price changes even in a short window such as 24 hours only. Due to the volatile nature of crypto, you might make less money from arbitrage trading than you had intended.
How to Find a DeFi Arbitrage Opportunity
Now that you have the answer to "How does arbitrage work?", the next burning question would be, " How can I find these opportunities?". One method is to compare asset prices across several protocols and exchanges manually. Given how quickly prices can fluctuate, this can be time-consuming and is not always accurate. A preferable method is tracking prices in real-time using a program like the DeFi Pulse index or Codefi Data. You may quickly and easily use these tools to determine which assets are under or overpriced on several exchanges.
When you discover a DeFi arbitrage opportunity, you can either trade directly on a DeFi built on the Ethereum network or utilize a service like Paraswap to have the deal executed for you automatically.
The beautiful thing about crypto arbitrage trading, whether you're a novice trader or an experienced investor, is that there are several systems available today that automate the process of locating and trading price disparities across numerous exchanges. These platforms can provide traders searching for a low-risk, hands-off trading option with a tremendous passive income possibility. Nevertheless, don't lose sight of the possible risks, however small they might be.
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