What is arbitrage trading and how does it work?

What is arbitrage trading?

Arbitrage trading is a trading strategy in which traders attempt to profit from price differences of financial instruments across different trading platforms. The classic example is simple: you buy an asset at a lower price on platform A and sell it almost simultaneously on platform B, where the price is slightly higher. The price difference represents the profit, while transaction costs paid to execute trades on the trading platforms must be taken into account.

This form of trading is often considered a strategy with relatively low risk, because the trader does not rely on price predictions, but on existing market inefficiencies. Arbitrage trading is applied to various financial instruments, such as stocks, ETFs, currencies, commodities, and cryptocurrencies.

Key takeaways

• Arbitrage trading is a trading strategy that exploits price differences of the same asset across different markets or trading platforms without speculating on price direction.
• Arbitrage crypto trading occurs relatively often due to differences in liquidity, trading costs, and the lack of centralized price synchronization between crypto exchanges and blockchains.
• Common arbitrage strategies within crypto include spatial arbitrage, triangular arbitrage, and cross-chain arbitrage, where speed and simultaneous execution are essential.
• Automation and trading bots play a crucial role in arbitrage trading, as price differences often exist for only a few seconds or minutes.

How does arbitrage trading work?

Arbitrage trading operates based on market imperfections that arise when the same asset is temporarily traded at different prices across multiple markets or trading platforms. In a fully efficient market, there would be little to no price differences, but in practice this is almost never the case. Especially with smaller financial instruments, inefficiencies regularly occur, creating opportunities for arbitrage traders.

These price differences across trading platforms arise due to several factors:

• Liquidity, because on an exchange with low trading volume the price can deviate more quickly than on an exchange with deep order books.
• Trading activity, because a high level of active trading leads to faster price adjustments. On platforms where many traders are active simultaneously, new price information and order flows are processed more quickly. On less active exchanges, prices may lag behind the broader market, creating temporary arbitrage opportunities.
• Regional supply and demand, because it may occur that there is higher demand for an asset in Europe than in the United States, leading to higher trading volumes and therefore higher prices on European trading platforms.
• Delays in price updates between trading platforms, meaning prices are not always updated simultaneously.
• Independent operation of crypto platforms, because within the crypto market both centralized exchanges and decentralized exchanges (DEXs) operate independently and prices are not centrally synchronized.
• Transaction costs, because differences in trading fees, withdrawal fees, and network fees influence trader behavior. Exchanges with lower costs often attract more trading activity, while higher costs can prevent small price differences from being arbitraged away immediately, allowing arbitrage opportunities to persist longer.

The arbitrage trading process

An arbitrage trade typically consists of three consecutive steps:

Step 1: identifying a price difference.
This involves the trader or an automated system monitoring multiple markets simultaneously and detecting that the same asset is being traded at different prices.

Step 2: executing a buy and sell order simultaneously.
This is crucial, because the price difference often exists only briefly. Once other market participants notice the difference, the inefficiency disappears quickly. Executing both positions almost simultaneously ensures the trader has no exposure to price movements.

Step 3: settlement of the transactions.
Here, the purchased assets are delivered and the sale is completed, after which the profit is realized through the price difference. Transaction costs, trading fees, and any network fees must always be included, as they strongly affect the final return. It is therefore important to carefully select trading platforms, as high fees can significantly reduce potential profits.

Example:
Suppose Bitcoin is traded on two different crypto exchanges. On exchange A, the price of Bitcoin is €50,000, while on exchange B, Bitcoin is offered at €50,300. This price difference may arise because exchange B is experiencing more buying pressure at that moment than exchange A.

In this case, an arbitrage trader can buy Bitcoin on exchange A for €50,000 and sell it almost simultaneously on exchange B for €50,300. In theory, the gross profit is €300 per Bitcoin. In practice, trading fees, deposit and withdrawal fees, and any network fees must be deducted.

To execute this arbitrage efficiently, many arbitrage traders maintain balances on multiple trading platforms in advance. Suppose a trader has 0.5 BTC available on both exchanges. By selling 0.5 BTC on exchange B at €50,300 and simultaneously buying 0.5 BTC on exchange A at €50,000, a price difference of €300 per Bitcoin is captured. For 0.5 BTC, this results in a gross profit of €150, excluding costs.

Executing these transactions simultaneously is essential, because the price difference can disappear quickly. Precisely because arbitrage traders buy en masse on the cheaper exchange and sell on the more expensive exchange, prices converge and the arbitrage opportunity closes.

Arbitrage traders therefore buy and sell simultaneously, allowing them to capture the price difference without price risk and end up with the same amount of Bitcoin.

The role of speed and automation

Speed and timing are crucial in arbitrage trading. Price differences often exist for only a few seconds or minutes. For this reason, arbitrage trading in modern markets is increasingly executed using automated systems and trading bots.

These bots continuously scan for price differences across trading platforms and exchanges. Once they detect a price difference that is profitable after accounting for all costs, the bot automatically executes the corresponding trades. The conditions under which a bot executes a trade can be predefined by the trader.

Due to the required speed and timing, it is virtually impossible for human traders to consistently apply arbitrage trading, especially in markets that operate 24/7, such as the crypto market. Automation has therefore become essential for identifying and executing arbitrage opportunities in time.

Which arbitrage trading strategies exist?

There are various forms of arbitrage trading. Which strategy is applied largely depends on the market and the desired level of complexity:

• Spatial arbitrage:
  Spatial arbitrage is the most classic form of arbitrage trading and exploits price differences of the same asset across different exchanges. The trader buys on the exchange where the price is lower and sells simultaneously on the exchange where the price is higher.
• Statistical arbitrage:
  Statistical arbitrage is a more advanced strategy based on mathematical and statistical models. These models identify temporary deviations in historical price relationships and assume that prices will revert to a statistical mean over time.
• Triangular arbitrage:
  Triangular arbitrage uses three different trading pairs within a single market, often in the currency or crypto market. By executing a series of three consecutive transactions, a price inefficiency can be exploited without direct exposure to price direction.
• Intra-exchange arbitrage:
  Intra-exchange arbitrage occurs within a single trading platform and exploits price differences between different products or markets on the same exchange, such as between spot and futures markets.
• Cross-platform arbitrage:
  Cross-platform arbitrage exploits price differences between different types of trading platforms, such as centralized exchanges (CEXs, such as Finst) and decentralized exchanges (DEXs, such as Uniswap). Differences in liquidity and market structure can create arbitrage opportunities.

These strategies differ significantly and therefore each require their own approach, technical infrastructure, and risk management.

What is arbitrage crypto trading?

When we refer to arbitrage crypto trading, we mean arbitrage trading applied within the crypto market. Due to large differences in liquidity, trading costs, and the lack of centralized synchronization between large and smaller crypto exchanges, price differences occur relatively often, making arbitrage trading particularly suitable within this market.

Additionally, arbitrage trading plays an important role within DeFi, as it contributes to fair price discovery across different platforms. In combination with trading bots, arbitrage crypto trading has therefore grown into a popular strategy among both retail and professional traders.

Commonly used arbitrage crypto trading strategies

The crypto market lends itself to various arbitrage trading strategies that are used to exploit price differences in the market. The most commonly used strategy is spatial arbitrage, where a cryptocurrency is purchased on one exchange and almost simultaneously sold on another exchange where the price is higher.

In addition, triangular arbitrage is a widely used strategy. This involves combining three different trading pairs within a single trading platform to exploit temporary price inefficiencies within the same exchange, without exposure to price direction.

Cross-chain arbitrage is also increasingly applied. This strategy exploits price differences of the same cryptocurrency across different blockchains. It requires a solid understanding of blockchain technology, transaction costs, and network speed, as delays and fees have a direct impact on profitability.

All of these arbitrage crypto trading strategies require speed, technical infrastructure, and careful risk management, as price differences often exist only briefly.

Risks of arbitrage trading

Although arbitrage trading can be a successful and lucrative form of trading, it also carries risks:

• Transaction costs
  Trading fees, deposit and withdrawal fees, and network fees can partially or completely eliminate the price difference. Small arbitrage opportunities with limited margin are often only profitable when costs are very low.
• Slippage
  When an order is executed at a less favorable price than expected, for example due to a thin order book or sudden market movements, the intended arbitrage profit can quickly disappear.
• Execution delays
  Arbitrage trading is highly dependent on speed. Delays in order execution, API latency, or blockchain transactions can cause the price difference to disappear before the trade is completed.
• Liquidity risk
  With insufficient liquidity, a trade may not be fully or only partially executed, especially for larger orders, preventing the arbitrage position from being properly closed.
• Network and congestion risk (crypto)
  In the crypto market, high network congestion and rising gas fees can delay blockchain transactions or make them more expensive, negatively impacting profitability.
• Operational risk
  Errors in trading bots, incorrect settings, software bugs, or human mistakes can lead to unintended trades or loss of capital.
• Competition risk
  Arbitrage opportunities are often exploited quickly by multiple traders and bots. As a result, price differences disappear faster and profit margins decline.

Final thoughts

Arbitrage trading is a strategy that capitalizes on temporary price differences within financial markets and can therefore be a relatively low-risk trading approach. Instead of speculating on future price movements, arbitrage trading focuses on exploiting market inefficiencies caused by differences in liquidity, trading activity, cost structures, and market structure.

Within the crypto market, arbitrage trading occurs relatively frequently. Due to the decentralized nature of crypto, the independent operation of exchanges and blockchains, and continuous trading activity, price differences regularly arise that can be exploited by arbitrage traders. Strategies such as spatial arbitrage, triangular arbitrage, and cross-chain arbitrage play a key role in this context.

At the same time, arbitrage trading is not a risk-free strategy. Transaction costs, slippage, delays, liquidity issues, and operational errors can limit or even completely eliminate profitability. As a result, speed, technical infrastructure, and careful risk management are essential for success. In practice, automated systems and trading bots have therefore become indispensable, especially within the 24/7 crypto market.

Overall, arbitrage trading represents an important mechanism in both traditional financial markets and the crypto market. It contributes to efficient price discovery and market stability, but at the same time requires knowledge, discipline, and a realistic understanding of the associated risks.