Arbitrage trading is a trading approach that helps to profit by simultaneously purchasing an item in one market and selling it in another. This is usually performed when similar assets are traded on different exchanges. The price difference between these financial instruments should, in theory, be zero since they are the same asset.
The problem for an arbitrage trader, or arbitrageur, is not only identifying these price differences, but also trading them quickly. Because other arbitrage traders are likely to notice this price difference (the spread), the window of profitability generally ends quickly.
Types of arbitrage trading
Below are some of the most common arbitrage types which are used by traders in a variety of marketplaces.
Exchange arbitrage is the most common type of arbitrage trading in which a trader purchases a crypto asset on one exchange and sells it on another. The value of cryptocurrencies may fluctuate rapidly. If you check the order books for the same item on many exchanges, you’ll see that the prices nearly never match precisely at the same moment. Here is when arbitrage traders come into the picture. They try to gain from these little differences. This results in a more efficient underlying market since the price remains generally stable across numerous trading platforms. Market inefficiencies might be seen in this way as an opportunity.
Funding rate arbitrage:
Another type of arbitrage trading that cryptocurrency derivatives traders commonly engage in is funding rate arbitrage. In this type of strategy, a trader purchases a cryptocurrency and hedges its price movement with a futures contract on the same cryptocurrency that has a funding rate lower than the purchase price.
Triangular arbitrage is another highly popular type of arbitrage trading in the cryptocurrency market. In this type of arbitrage, a trader observes a price differential between three distinct cryptocurrencies and exchanges them with one another in a kind of loop.
Furthermore, while arbitrage deals are often low-risk, the returns are generally low. That implies that arbitrage traders must not only respond quickly, but also have a large amount of cash on hand to make it profitable.