You've probably heard of arbitrage trading and people getting filthy rich with no risk involved. Well, I would disagree with that statement in its absolute sense, but it's definitely less risky if compared to any other trading strategy.

Basically, what traders do, they take advantage of price differences across markets. To put it simply, BTC should theoretically have the same value both on Bittrex, Huobi, and Binance where every price deviation is an opportunity.

Here's an example.

John buys 1#BTC on Binance for $55,500 and sells it on Huobi for $55,550.

John made his first successful arbitrage trade. Of course, this is just a theoretical example of how arbitrage trading works.

This is a common strategy in the trading world, but it's mostly been a tool for either large players, or algorithms created for that same purpose. It's extremely hard to compete with them as a retailer with small capital - almost impossible.

However, given how volatile the crypto industry is, traders have a much easier time finding opportunities.

Highly Competitive Environment

What would you do if you were certain that the trade you take will likely be profitable? You would probably try to exploit the discrepancy until someone else joins and eliminates % of the profits you were making.

So, It's reasonable to assume that such a possibility will attract a lot of people, companies, and firms to compete. For this very reason, profits are generally very slim and highly dependent on how fast you can execute the trade, which means that the market has to be liquid enough to support many trades to be executed in a matter of seconds.

That's why high-frequency trading firms have the most success.

It's really unlikely for an individual to outperform algorithms, the only way is to spot a difference where there's no input for the algorithms to detect. The challenge is not to find the deviations, but to execute the process before someone else does. Given that profits are counted in 0.00x% you need a lot of capital to make it worth the trade, especially if you count transaction fees.

Moving forward, there are more types of arbitrage traders use to gain an advantage.

Types Of Arbitrage

Exchange arbitrage

The most common way of doing arbitrage is via exchanges.

The price of crypto is well known for being volatile. In case you compared the order books from different exchanges regarding the same assets, you'll rarely ever find that the prices are exactly the same. This is where arbitrage traders come in. Small exploits help the underlying market in a way of making it more efficient. It's like a vehicle that finds an equilibrium to keep the prices in an acceptable range.

Funding Rate

Another common type of arbitrage trading for crypto derivatives traders is funding rate arbitrage. This is when a trader buys a cryptocurrency and hedges it’s price movement with a futures contract in the same cryptocurrency that has a funding rate lower than the cost of purchasing the cryptocurrency. The cost, in this case, means any fees that the position may incur.

"Let’s say you own some Ethereum. Now you might be happy with that investment, but the price of Ethereum is going to fluctuate a lot. So you decide to hedge your price exposure by selling a futures contract (shorting) for the same value as your Ethereum investment. Let’s say the funding rate for that contract pays you 2%. That would mean you’d get 2% for owning Ethereum without any price risk, resulting in a profitable arbitrage opportunity."

There are a few more ways of catching the arbitrage, but those two I mentioned are the most common.

RISKS

As I said at the beginning, I don't think there's such thing as a 100% profitable trade. The logic behind is quite an easy one, if there's no risk, there will be no reward, and the arbitrage is no exception.

The biggest risk associated with arbitrage trading is execution risk. This happens when the spread between prices closes before you’re able to finalize the trade, resulting in zero or negative returns. This could be due to slippage, slow execution, abnormally high transaction costs, a sudden spike in volatility, etc.

As it turns out, there are a lot of things you gotta bear in mind before executing the operation. By the time you send/receive tokens the situation can change drastically, therefore it's not recommended for newbies to try it out.

Not to even mention the liquidity risk. This happens when there's not enough liq asset for you to get in and out of the markets. However, the rewards are proportional to the risk undertaken.

Remember, there's no such thing as free money, but arbitrage trading is as close as it gets.

DYOR before you do anything stupid haha.