Blockchain101: Ten Minute Talks: Arbitrage
Definition: To profit by buying an object in one place and selling it in another place at a profit.
As in take ownership of an asset or control of an asset.
As in give up ownership or control of an object.
- As in the total amount of money required to buy is less then the total amount gained by selling.
Math Skills Required
Addition, subtraction, multiplication.
Trading Knowledge & Skills
- The access to or ability to buy and sell on two different exchanges.
- The access to or knowledge of object prices on two exchanges.
- Money to buy objects in one place and
- The ability to move the object from the first place to the second place.
Market conditions: Liquid
- Two markets where the object bought and purchased is actively being traded, as in bought and sold.
- Which means if I offer to buy an object at the market price I will immediately be able to buy it, and if I offer the same object for sale on another exchange at the market price I will immediately be able to sell it.
- These are called Liquid markets or markets with good Liquidity.
Example of Arbitrage: @shortsegments buys Leo in the form of WLEO for 1 cent on the cryptocurrency exchange Uniswap, and sells Leo in the form of BLEO on the cryptocurrency exchange Pancakeswap for 2 cents.
- @shortsegments buys 100 WLEO on Uniswap for 1 cents, or 100 times 1 cent, or 100 cents.
- @shortsegments sells 100 BLEO on Pancakeswap for 2 cents, or 100 times 2, or 200 cents.
- @shortsegments profit is the difference between the cost of buying 100 cents and the amount gained from buying 200 cents.
- In this example the amount @shortsegments received for selling was 200 cents.
- The amount @shortsegments spent buying was 100 cents.
- The difference 200-100 is the profit. In this case 100 cents.
Math continued: But to determine if this arbitrage deal is really profitable, we have to consider any transaction fees.
- The amount you pay an exchange for buying or selling there.
Math Continued: Now when we look at this arbitrage event and we say transaction fees on the Uniswap exchange were 1 cent, and the transaction fees on PanCakeSwap were 1 cent, we have total transaction fees of 1 + 1, or 2 cents. We now subtract that from the 100 cents number we obtained above to get 100-2= 98 cents as our final profit.
Let’s look at the numbers Buy 100 WLEO for 1 cent, 100x1=100 cents. Pay Transaction fee 1 cent, 100+1=101 cents. Sell 100 BLEO for 2 cents, 200 cents, pay transaction fee 1 cent, 200-1=199. Subtract 101 from 199, 199-101=98 cents profit.
Arbitrage Definition: To profit by buying an object in one place and selling it in another place at a profit.
- As in the amount of money required to buy is less then the amount gained by selling.
Why our arbitrage was profitable: Math & Words.
We bought Leo for 1 cent as WLEO We sold Leo for 2 cents as BLEO We paid 100 cents plus 1 cent transaction fee to buy. We received 200 cents, minus a 1 cent transaction fee to sell. We profited because our cost of 101 cents; the price of 100 WLEO + 1 cent transaction fee, was less then what we received to sell BLEO ; 200 cents, minus 1 cent transaction fee. 200-1, 199-101=98.
- Requires a price difference on two exchanges.
- Arbitrage requires Liquid Markets, as in market buy or sell orders are filled quickly.
- ‘Arbitrage requires the ability to move objects from one market to another.
- Arbitrage does not require buying and waiting for the number to go up, as in buy low sell high.
- Arbitrage results in an immediate profit, as long as the transaction costs don’t exceed the price differential.
Arbitrage is responsible for the majority of cryptocurrency trade volume on all exchanges every day. Arbitrage trading is a big profit maker in most markets, including stocks, bonds, commodities and futures.
As you can see, transaction fees are either a facilitator or an impediment to arbitrage trading. But it is all dependent on the size of the arbitrage trade. A 50 cent trading fee is much bigger then a 1 cent trading fee. But it is only significant if the profits are measured in 100 cents, 200 cents, 300 cents, etc. It’s not a big factor if the profits are measured in 100 dollars, 200 dollars or 300 dollars. So even markets with high trading fees can have large numbers of arbitrage sales, if the markets are liquid.
Thus Liquidity is one of the most important factors in an cryptocurrency exchange market’s success.
@shortsegments , penned by my hand 30 January, 2022.
Title Photo Credits
Title photo by: Photo by Fractal Energy Storage Consultants. Source: https://avs431.medium.com/explain-it-to-me-like-i-am-a-5-year-old-basic-trading-strategies-arbitrage-hedging-fb02953d08a2
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