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Arnaud Deblander
May 13, 2022 1:49 PM

In the previous article, we discussed a topic that is very topical, trading in bearish periods. With the current market storm, a little help is welcome. Instead of trend trading, we will explore another alternative strategy that could help you profit from the current state of the crypto market.

Trend trading is possibly one of the most widely used strategies across crypto and traditional markets. But what is your alternative during a time such as now? A strategy that doesn’t necessarily have to rely on a directional trend! We will of course talk about arbitrage!

What is arbitrage trading?

Before we get into crypto arbitrage strategies, it’s important to first know what arbitrage is and why it exists. As you all know, the stock market is a global market where all sorts of assets are traded, from precious metals to stocks to wheat.

However, there is not only one centralized world stock exchange but several exchange platforms such as the New York Stock Exchange (NYSE) or the Frankfurt Stock Exchange. With the speed of information exchange of our current era, prices are almost the same everywhere at the same time, albeit there are still price differences between the exchanges. Crypto exchanges are no different.

This difference in prices is fundamental because there are indeed small differences in quotation between the different world stock exchanges and this is where the possibility of arbitrage is born. One can indeed buy an asset A at a price on a quotation place A and sell it a little more expensive on another quotation place, thus pocketing the difference.

On the classical market, arbitrages take place almost every second and are performed by ultra-sophisticated algorithms. A human eye would be too slow to compete in this area.

Crypto arbitrage

The principle is exactly the same for the crypto market, except that there are many more exchange platforms than on the classic market, so more arbitrage possibilities. To name a few: Binance, Kucoin, Huobi, FTX, all these platforms have slightly different prices which imply that a possibility of arbitrage between two exchanges exists.

Unlike the classical market where taking advantage of them is simply impossible for the average investor, arbitrage in the crypto market is more accessible. The reason is simple: the market is not yet as efficient as the classical market, but the increasing institutionalization of the latter is pushing it towards more efficiency progressively.

Nevertheless, it remains possible, for the moment, for someone who knows how to code algorithms, to take advantage of these market inefficiencies.

Arbitrage trading on DEX VS CEX

As you know, there are primarily two different types of exchange platforms in the crypto market – centralized exchanges like Binance and decentralized exchanges like Uniswap.

On centralized exchange platforms, arbitrage opportunities exist but are more likely to be quickly erased. These platforms enjoy a higher trading volume and a model that is similar in every way to that of the traditional market. Since centralized trading platforms use external and internal market makers, the latter are generally the ones who benefit from the majority of arbitrage opportunities.

On decentralized trading platforms, on the other hand, arbitrage is much simpler and more accessible, even if it requires some sophistication. Arbitrage on a decentralized platform is performed in most cases by a smart contract, which can perform several trades in one.

The different types of arbitrage

Centralized Exchanges

Regular arbitrage

Let’s take the case of centralized platforms first! The simplest form of arbitrage, but also the most difficult to exploit, is regular arbitrage between two exchanges. This is the example we discussed above, buying an asset cheaper in A and selling it more expensive in B to pocket the difference.

This type of arbitrage is quite difficult for the average investor to exploit because of its simplicity and therefore tends to be spotted and exploited almost instantly by institutions.

Triangular arbitrage

Triangular arbitrage involves price differences between three currencies in the same market. In this case, you try to take advantage of the price differences by making several conversions. For example, you buy BTC with USDT, sell BTC for LINK, and convert the LINK back to USDT. This is a type of arbitrage that must be done quickly and must be computerized. A human would indeed be too slow.

Decentralized Exchanges

On a decentralized exchange platform, as mentioned above, we can develop a smart contract that takes care of everything. Isn’t that great? Yes, but not all smart contract developers are the same.

We can distinguish 3 types of sophistication in an arbitrage contract on DEX:

  • The most sophisticated take advantage of gas tokens, flash loans, mempool transaction replacement, and trade batching (wrapping multiple trades across one or more DEXes into a single transaction).

  • Intermediate arbitrage contracts only use trade batching to wrap multiple trades across one or more DEXes into a single transaction.

  • The latter do not batch trade at all.

Conclusion

To conclude, yes arbitrage can be profitable but it is not without risk. There are many factors that can turn a theoretical gain into a real loss, such as the speed of execution or the costs associated with trading.

Given that the current market is risk-off, it doesn’t mean that you have to sit idle. Using this time to brush up your trading skill, explore and learn about other strategies is a wise move.

One golden rule in trading and investing – don’t bet against the market. Instead, go with the flow, and as with any strategy, directional or not, preparation and research will be your best bet!