What is Arbitrage?

Markets like cryptocurrency or traditional stock exchanges are inefficient by design. Some of the reasons for this inefficiency are the uneven information access across all market participants, varied trading tools and strategies, costs of transactions, and others.

These variables can lead to the prices of the same assets – whether traditional or digital – being inconsistent throughout the different market platforms. Traders who are aware of this varying information and know how to use it to their advantage to maximize their profits are known as arbitrage traders.

Arbitrage trading is a strategy of buying an asset where it is listed cheaper and selling it in a market where its price is higher nearly simultaneously. This phenomenon exists thanks to market inefficiencies.

Arbitrage traders, also known as arbitrageurs, increase their profits, make markets more efficient, and ensure that the pricing of the same asset is similar across a number of different exchanges.

As arbitrageurs buy the asset at a lower price on one exchange and sell it for more on the other, the divide between the exchanges is reduced. This lowers the window of opportunity for arbitrage trading, making the markets more efficient.

Arbitrage trading ensures that assets do not deviate from their fair value for an extended time. It also enhances the liquidity flow between different exchanges.

Since arbitrage trading is executed as the same quantity of an asset being purchased and sold on different exchanges, there is little to no risk on the strategy for the arbitrageur.

However, the aspect of the speed of arbitrage may be risky, since the trading needs to be executed nearly instantaneously on multiple exchanges. There is also a high cost of trading, known as commissions, which the arbitrageurs have to pay on the different exchanges.

Arbitrage trading can occur between two or more markets, using one or more assets. An arbitrageur can purchase cryptocurrency as an asset for $30,254 per coin on exchange A. They then sell it for $30,476 on exchange B.

More complex trades that involve the exchange of three different assets across three different markets are known as triangular arbitrage.

Due to technological advancements and automated trading, there are fewer opportunities for fast-paced arbitrage trading. Despite this, given the continued existence of market inefficiencies, arbitrage remains a vital part of inter-market trading.