Leveraging price variation across exchanges: The Arbitrage.
If you are a chart watcher like myself, you’ll notice slight price variations on different exchanges. For the majority, this variation is too ‘small’ and ‘not tangible’. Price variation across different market pairs and different exchanges is known as price Arbitrage. These variations are usually due to difference in demand and purchasing pressure across these exchanges and pairs. Usually these variations last for only a short while before leveling up with the rest of the market. Unarguably, the offset in price is usually slight, but they could mean a whole lot…if used correctly.
The popular practice is cryptocurrency traders and investors trading against time and exploiting the periodic variation in values of cryptocurrencies to make gains. Traders are more actively involved this race against time and demand. Time and demand play a role in the overall value of an asset, this is a popular concept. But, the effect of time and demand on the value of an asset on different markets is relatively less popular, ‘ignored’ is a more appropriate term. Even in our everyday markets, the price of a commodity doesn’t stay same in different markets, the cryptocurrency markets aren’t different as regards this. Market-to-market price fluctuation is commonly overlooked, not just in cryptocurrency but also in mainstream trading scenarios. This market to market variation in the value of an asset form the crux of Arbitrage trading.
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Differences in price across exchanges can be influenced by the purchasing power of an exchange, this is determined by the ‘wallet weight’ of the traders using these exchanges. The amount of ‘rich buyers’ (whales) in an exchange determines the purchase pressure on the said exchange. This is evident in the impressive spread and high transaction volumes. Such pressure could result in the order books moving slightly faster on the concerned exchange.
Whale influence drives price, more buy force from whales in market slims down the sell orders while driving the buy orders up and creating a good liquidity. This can also go either way, bringing prices down faster. When this happens at different speeds and at different times in different markets, price variation occurs. This is normal and price variation can be up to 50%. Whichever way the variation goes, provided a difference is created, an Arbitrage trader can swing into action and take advantage of this.
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Basically, Arbitrage trading consists of three processes:
- Detecting variations in the value of an asset across different exchanges or trading pairs.
- Purchasing assets at this reduced price.
- Selling the purchased asset at the higher price on another exchange or trading pair.
Easy, huh? Well, not really. Arbitrage trading is a notably risky venture, just like any other trading activity. However, there seem to be an increased risk, probably why it hasn’t been able to gain huge popularity. Trading arbitrage involves managing a host of risks. These risks normally arise due to the fast-changing prices and practices by exchanges.
Sometimes the prices differences levels up after a very brief moment, things could go either way too. Many times, these differences don’t actually exist and the noticed variation is only due to an uneven spread between the buy orders and the sell orders. In the quest to act fast, an arbitrage trader stands a chance of not noticing this development. When this happens, the most possible event is selling at a loss, or playing a longer game of time. Sometimes an arbitrage trader could get stuck due to this.
When trading arbitrages across different exchanges for assets which attracts tangible withdrawal fees, the risk of losses are increased, relative to the fees. As an arbitrage trader moves assets across exchanges, more spillage and expenses are incurred. To cover up these technical losses, an arbitrage trader must generate a positive net profit. One way to do this is by increasing the purchasing power to maximize the gains. Purchasing power however depends on what the trader can afford, there are strict limits to this.
Arbitrage trading is a game of numbers, speed and cleverness. Quantity influences the chances of making profit from an arbitrage trade. Acting ‘fast’ is also a vital quality of a good arbitrage trader. Net arbitrage return is obtained by deducting the exchange withdrawal charges and other technical costs from the gross profit. Increasing purchase to compensate for trading and withdrawal charges could also be a good practice. Capitalizing on price variation is profitable practice, however, the sale and buy orders in both markets should be considered. Thin buy orders on target market could lead to substantial losses. Inability to win the race against time also results in losses. Best practice would be targeting wide arbitrage in low withdrawal fee assets. This doesn’t come frequently. But when done right, arbitrage trading could prove lucrative.
