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Trading in financial markets has been gaining momentum in recent years, attracting millions of people. Foreign, stock, and crypto exchanges are among the most popular financial markets.
The popularity of trading has increased vastly due to the growth of blockchain and decentralized space. Investors want to trade with different cryptocurrencies, including Ethereum, Bitcoin, Algorand, and many others.
However, to have success in trading, investors often imply different strategies. One of the trading strategies known to investors is Arbitrage trading. So, what is arbitrage trading, and how does it work? Keep reading.
What is Arbitrage Trading?
By definition, Arbitrage trading involves taking advantage of minor price differences of the same asset but in different markets. It works with short-term price variations. The trader purchases a commodity, be it stock, currency, or crypto, from one market at a low price and sells it to another market at slightly higher prices. Both trades happen simultaneously.
In arbitrage trading, the main idea is to make just a tiny fraction of profit from every successful trade. Experts believe that arbitrage trading helps maintain balance in the markets. It ensures that market prices will not deviate from actual values for a long time.
Understanding How Arbitrage Trading Works
While exploring how the network functions, it’s vital for the investors to understand the different aspects of this type of trading. This section looks at the basics, characteristics, and types of arbitrage trading.
The Basics Explored
In arbitrage trading, the idea is to maximize the short-term price differences of an asset in two different markets. To understand how arbitrage trading works, consider asset A, Ethereum trading in multiple exchanges like Kucoin, Kraken, Binance, and Coinbase.
However, as trading of the asset continues, there is a possibility that Ethereum prices will not be in sync in all exchanges. ETH may trade at less or higher than the actual value depending on your choice of exchange.
Consider that at some point, Ethereum prices in Kucoin, Binance, Kraken, and Coinbase are $2507, $2517, $2537, and $2557, respectively. At this point, the value of the assets in all those exchanges is different, with Kucoin being the lowest.
An arbitrage trader will purchase the assets from an exchange with low prices, in this case, Kucoin. The trader simultaneously sells the purchased asset to another exchange, Kraken, Binance, or Coinbase.
Hence, by this illustration, arbitrage trading means buying the asset from one exchange and selling it to another at a higher price. It’s a simple buy low and sells higher trade. As mentioned above, the price differences could be minimal but can result in profit. Arbitrage trading is mostly a quick trade. Since these transactions occur concurrently, the trader has very minimal risks associated.
But, what causes the price inefficiencies? The issues causing the price differences between different markets and exchanges are demand and supply. If demand or supply factors change slightly, it could cause immediate but minimal price changes in assets. For an arbitrage trade to occur, the following conditions must be met;
- Asset price imbalances. You deal with the same asset but price differences in markets.
- Execute trades simultaneously. For a trade to be arbitrage, two trades must be executed simultaneously in different exchanges, one buy, and one sell.
The Technical Aspect of Arbitrage Trading
Being a very profitable and low-risk trading style, investors may want to know why it is not highly used. The simple answer is that arbitrage trading lasts very few minutes; hence the chances do not last. Basically, due to technological development, the price deviations are resolved as soon as noticed.
Hence, it’s not easy for rookie or even expert traders to identify the price gaps between exchanges. This is where the technical side of arbitrage trading comes in.
Arbitrage traders use automated systems that help them identify short-term fluctuations. These algorithms are linked to different exchanges and can give signals when they spot price differences. The softwares can highlight the exchanges and assets involved. The system identifies on-the-spot price differences; hence investors can instantly exploit them.
Several Types of Arbitrage Trading
There are several types of arbitrage trading, all distinguished by the length of trade and risk levels. Among the different types of arbitrage trading include;
- Simple arbitrage. Simple arbitrage is the type of trading that involves buying and selling an asset in two different markets. You take advantage of short-term price differences in other exchanges.
- Merger arbitrage. Merger arbitrage involves acquiring public companies. It’s long-term, and there is never a certainty that prices will go higher.
- Triangular arbitrage. Triangular arbitrage is a type of trading involving three pairs of currencies. For instance, a trader may use BTC to buy ETH, then use ETH to buy ADA, and finally use ADA to purchase BTC. In the process, a trader could make some profits.
Final Word
This guide explores the concept of arbitrage trading and how it works. Arbitrage trading is buying an asset at a low price and selling at higher prices between markets. Arbitrage traders leverage softwares to spot the price differences and invest. One thing to remember is that arbitrage trading can help generate quick gains for investors.
For persons investing in digital currencies like Algorand and other Defi tokens, arbitrage trading can be a good strategy to earn income. However, ensure you grasp the concept before you start trading.
