Arbitrage trader is a popular trading strategy as a result of its relative low risk. This trading strategy aims to take advantage of price differences across markets, making it popular amongst crypto traders and investors alike.
In this article, we’ll explain everything you need to know about arbitrage trading strategies, including how this type of trading works and where the risks lie.
What Is Arbitrage Trading, Anyway?
Arbitrage trading takes advantage of the price differences between stock markets. When an individual asset is trading at different prices across two different markets, an arbitrage trader will purchase the asset for the lower price and then sell it on the other exchange for a profit.
It’s important to note that the price difference between the markets is usually relatively low, making profits from arbitrage trading lower than with other types of trading. Arbitrage trading is also subject to high transaction fees, but it is favoured amongst many traders for its relative low risks due to the speed at which the transactions are carried out.
Read on to learn exactly how arbitrage trading works, the pros and cons of this popular trading strategy and whether it’s the right path for you to take.
How Does Arbitrage Work?
The reason that arbitrage trading is effective is due to the inherent inefficiencies which are present within the financial markets. These markets are driven by supply and demand, so a sudden change in either of these things can have an impact on the price of an asset.
Arbitrage traders look for these differences in price between the markets as a result of the differing levels of supply and demand, taking advantage of these discrepancies. This can result in low risk profits for the trader.
Many arbitrage traders utilise automated trading systems which use algorithms to identify discrepancies in price. This allows the trader to quickly profit from the price differences before it becomes more widely known, causing the markets to even out.
Types Of Arbitrage Trading
There are a few different types of arbitrage trading that you should be aware of. For the purposes of this article, we’ll focus on the three main types.
Exchange arbitrage is the arbitrage trading strategy we’ve already discussed. It involves identifying price differences between two identical assets within different markets and exchanging them in order to make a profit from the difference. The asset it purchased from the exchange with the lower price and then sold on the exchange where the price is higher.
This price difference is the result of supply and demand. When supply is high and demand is low, the price will drop. Once supply lowers and demand increases, the price will rise. Arbitrage traders identify this discrepancy and act quickly to profit from the price difference.
Covered Interest Arbitrage
Covered interest arbitrage involves taking advantage of the interest rate differential between two different currencies. This is done using a forward contract which locks in an exchange rate, whilst buying currency at the current price.
For example, if a trader recognised that the interest rate in Europe was better than in the UK, they could convert GBP into Euros at the same time as organising a forward contract with a fixed exchange rate on EUR/GBP in order to hedge against any shifts in the exchange rate over the investment period.
After securing the interest rate payments on the Euros, the trader would then convert the Euros back to GBP using the exchange rate guaranteed by the forward contract.
Triangular arbitrage aims to take advantage in the discrepancy between three foreign currencies, when the exchange rates do not exactly match up. It involves converting currency into two others before converting it back into the first currency at a profit.
Opportunities to use triangular arbitrage are rare and don’t arise often. Traders who take advantage of triangular arbitrage typically use complex algorithms to identify the opportunities and automatically make these trades.
Pros And Cons Of Arbitrage Trading
There are both pros and cons of arbitrage trading, which need to be carefully weighed up before deciding to give arbitrage trading a go. Let’s take a look at some of the pros and cons of this trading strategy.
|✅ Lower risk||❌ High transaction fees|
|✅ Increases market liquidity||❌ Initial outlay|
|✅ Not reliant on strong markets||❌ Complex nature|
Benefits Of Arbitrage Trading
Arbitrage trading is a popular trading strategy, so it goes without saying that there are several benefits of arbitrage trading which cannot be ignored. Here are some of the advantages of arbitrage trading.
One of the biggest advantages of arbitrage trading is that is offers lower risk opportunities to traders. Most strategies are market neutral, meaning that the long term risk is limited. When the market is particularly volatile, arbitrage trading allows investors to take advantage of price differentials to earn a profit.
Increases Market Liquidity
Not only is arbitrage trading good for traders, but it’s also good for the market. This is because arbitrage trading increases liquidity in the market, improving its efficiency. This contributes to the fair and efficient pricing of the futures markets.
Strong Performance Even In Downward Markets
Whilst many types of trading may become less profitable in a downward market, arbitrage trading relies on the market being volatile. This means that opportunities for arbitrage traders are not limited by poor performance in the financial markets. Providing you can identify significant market-moving information, you can make a profit through arbitrage trading, no matter how poorly the market may be performing.
Downsides Of Arbitrage Trading
Despite the benefits of arbitrage trading, it’s important to also consider the disadvantages and risks involved with this trading strategy. Here are some of the downsides of arbitrage trading, which you should consider carefully before deciding to give this trading strategy a try.
High Transaction Fees
When considering the potential profits of arbitrage trading, many traders forget to take note of the transaction costs and taxes related to the purchase and sale of shares. These fees can sometimes be higher than the profit that you make from a trade, causing arbitrage traders to make a loss. For this reason, it’s important to be aware of the related fees before making arbitrage trades.
Arbitrage trading relies on the differences in prices across different markets. This price difference is often small, meaning that the profits associated with arbitrage trading are low. This means that traders who want to earn substantial profits from arbitrage trading need to invest considerable amounts of capital upfront to be able to make substantial profits.
As you may have noticed already in this article, arbitrage trading is complex in nature and can be difficult for beginners to get a grasp of. It also comes with risks, such as an execution risk when an arbitrage trade can’t be completed within the stipulated timeframe and a liquidity risk when the asset cannot be sold in the second exchange as planned.
The complexities of arbitrage trading mean that it’s difficult to get started and easy to make mistakes. This is why many beginners are unsuccessful in their attempts to become a profitable arbitrage trader.
Is Arbitrage Trading Legal?
Arbitrage trading is legal in most countries of the world. Not only that, but it is actually encouraged by many markets. This is because arbitrage trading helps to maintain the liquidity of markets through the buying and selling of shares across exchanges.
This trading strategy is extremely beneficial for the financial markets, helping them to operate more efficiently. For this reason, arbitrage trading is not only legal but encouraged.
Can You Make Money Through Arbitrage?
Many traders are successfully earning a regular profit from arbitrage trading. This lower risk trading strategy allows traders to take advantage of discrepancies across different exchanges, profiting from the differences.
However, it can be difficult to get started with arbitrage trading due to the complexities of the strategy. It also requires a high upfront investment due to the low profit margins typically involved.
Automating Arbitrage Trading With Bots
We’ve already discussed just how complex arbitrage trading can be. Keeping an eye on several different markets in an attempt to discover a discrepancy in pricing is not only difficult but also inefficient. That’s why many arbitrage traders turn to automated trading systems to help them along the way.
Automated trade bots can be used to alert the trader when a price discrepancy occurs across different markets. This enables the trader to take advantage of the differences by purchasing stocks from the market with the lower price to sell to the market with the high price.
There are also automated trading systems which enable traders to earn passive income through fully automated trading strategies. These trade bots are able to place trades automatically, with no human input, allowing the trader to earn a passive income without lifting a finger.
However, automated trading systems come with their own risks. Like any form of technology, trade bots can have their issues. Technical failures can lead to trades being placed erroneously or missed out on, so regular monitoring is required to keep the trade bot in check.
The Best Trading Strategy For Beginners
Whilst many traders are earning a profit from arbitrage trading, it isn’t necessarily the most straightforward trading strategy for novice traders to get involved with. Its complexities and subtleties make it difficult to learn and easy to make mistakes, and arbitrage trading typically requires a high level of upfront investment to make a significant profit. However, there is another type of trading which is well-suited to beginner traders.
Copy trading allows you to mimic the trading actions of a more established trader, buying and selling stock, forex or cryptocurrency at the same time as your chosen trader. This trading strategy allows you to jump head first into the world of trading, with the security of knowing that you’re being guided by an experienced trader.
With copy trading, you can choose to set up an alert whenever your chosen trader makes a trade. This means that you can evaluate the trade and make decisions based on your own strategy. Alternatively, you can use an automated trading system to copy every trading action that your selected trader makes.
If you’re looking to get started with trading, copy trading is a great place to start. Although the potential risks can be higher than with arbitrage trading, choosing the right trader to follow will help to minimise your risk. Additionally, copy trading requires a lower level of initial investment with the potential to generate higher profits. What’s not to like?
Is Bitcoin Arbitrage Profitable?
Bitcoin arbitrage has great potential for profitability, with low levels of risk. However, this trading strategy typically requires a high initial investment in order to generate a significant level of profit. It also comes with many complexities, making it difficult to get started in arbitrage trading.
Is Arbitrage Trading Risk Free?
As with any type of trading, arbitrage trading carries a risk. However, the level of risk that comes with arbitrage trading is lower than with traditional trading. This is due to the speed at which transactions are carried out, with the sale typically occurring moments after the purchase. It’s important to be aware that no form of trading is without risks and your capital may be at risk, no matter how low that risk is.
Looking For An Alternative To Arbitrage Trading?
Arbitrage trading is a lower risk way for traders to invest in the markets and earn a profit. However, it requires a high initial investment and requires both time and dedication to become a successful arbitrage trader.
Copy trading offers an alternative trading strategy to beginners who are looking to get started with trading. It’s also ideal for experienced traders who are looking to branch into new markets but don’t have the time to dedicate to studying the markets and watching graphs.
If you’re thinking about giving copy trading a try, I’m here to help. I’ve tried, tested and reviewed over 100 copy trading services over the past decade. You could even say that I’ve made all of the mistakes along the way so that you don’t have to.
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I’m Jon, owner of Trade Wise at https://tradewise.community/ and https://www.youtube.com/channel/UC7VmOx8DbvX4Rbrac2pPcjw
I review forex and crypto trading products and services to find the best of what’s out there for creating a passive income without becoming a full-time trader.