For today’s article I am going to take a look at arbitrage, a way of making profit off differences in prices across different exchanges. It’s not a way that really works for most people, as bots rule this world, but it is something that is relatively important to understand, as it is one of underlying mechanisms for keeping the price relatively stable across the different protocols and exchanges.
For the usual disclosure, I am not a financial advisor, I don’t even work in finance at all. My day job is as a telecommunications software engineer. Treat everything you read here as some educational resources and not financial advice.
What Is Arbitrage
Arbitrage is basically taking the basic fundamental of trading — Buy Low and Sell High — and applying it in a slightly different way. It’s also not related solely to crypto, as it is a common occurrence in other financial sectors. Instead of banking on a price change of an asset, you are taking advantage of price differences between different places, and these trades are fast, generally happening within a few minutes, sometimes within a few seconds, even within the same transaction, as bots are out there ruling the arbitrage game.
While technically “less risky” than say day trading, due to the fact that you are only dealing with current prices and not with any potential changes in price, there is a major disadvantage that if you are not first in line to run the trades, you’re not going to make any profit, and could actually end up in the loss, especially when you factor in transaction and swap fees.
There a couple of different flavors of arbitrage, so we’ll cover them in different sections and get a little more involved with how they work.
The simple arbitrage is the easiest to understand, as it’s a pretty straight forward process. Let’s imagine we are looking at the price of Bitcoin on Binance and Coinbase. Binance has it listed for $45,000 and Coinbase has it for $45,010. This gives you a price discrepancy of $10, so you could buy some Bitcoin over on Binance, send it over to Coinbase and then sell it for a profit.
Now, the first thing to think about here is the fact that you can’t just take an unlimited amount of money and buy just a crapload of Bitcoin and then go and sell it for profit. The act of buying it on Binance is going to drive it’s price up, and then the act of selling it on Coinbase will drive the price there down. So you have to factor in an equilibrium point, where you can buy an amount to sell, that will end up having the prices more or less equal, but that is going to rely heavily on how much market depth there is on both exchanges.
You’ll also have to factor in fees, with a $10 profit, it’s pretty easy to cover those, but if you are talking even smaller differences in prices, it can quickly become something that eats a large chunk of your profits away. For this simple transaction, you have the trading fees on both platforms, plus the transaction fee on the Bitcoin network for sending the funds between the exchanges.
And to win your profits, you are also in a race against anyone else who may have noticed that there was a price difference and is doing the same thing as you are, because the first one to cross the finish line is going to sweep up all the profits. And you’ll more than likely be racing against trading bots, so good luck with that part.
You may be able to find opportunities on smaller, lesser known exchanges, or on lesser known cryptos, but of course, that comes with a lot higher risk, and you’ll be dabbling in potentially sketchy sites, so it’s not likely to be worth all the hassle and increased risk.
This one is where things start to get a little more muddy, because it involves three pairings, hence the triangular name. We’ll walk through an example here using an Uniswap and Ethereum liquidity pool. As usual, I’m going to use arbitrary numbers to help make the math a little easier. The three pairings would be USD/UNI, USD/ETH and the UNI/ETH pool.
We’ll put the price of Uniswap at $30 and the price of Ethereum at $3000. The UNI/ETH pool has a rate of 90 UNI per ETH.
First, we’ll take $1500 and buy ourselves 50 UNI tokens, and then swap them in the LP for 0.556 ETH. We can then turn around and sell our ETH for a few cents over $1666 dollars, giving us a profit of a little over $111.
Now of course the same restrictions are going to apply here as with the simple one. As you exchange your UNI for ETH in the liquidity pool, you are going to be affecting the price, so it doesn’t have an unlimited amount you can just pump through for profit. And you’re racing against the bots and other traders, so you have to be first through the gate to make your profit.
Don’t forget about the fees either, as they are going to be very much a factor in the more complicated arbitrage plays, as you now have even more transactions happening, so the fees will build up.
In theory, you could also have more than just three pairs in your chain, there really is no real limit, but the more things you need to run through, the harder it would be to find the price inefficiencies to begin with, and even harder to pull them off quick enough, and cheap enough given the fees involved.
Arbitrage is definitely a profitable endeavor, there is a reason it’s been done for many years, and across many financial sectors, but it’s just not something that a common person can really benefit from to any great extent. Even with bots, there is lots of competition out there, so I personally think there are far better ways to earn profit than trying to play the arbitrage game.
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Binance — large centralized exchange — referral link saves you 10% on trading fees
Coinbase — basic crypto exchange — referral link gets you bonus crypto on first deposit
Cointiply — very good crypto faucet and earning site — no bonus for you on this referral unfortunately
Originally Posted On My Website: https://ninjawingnut.xyz/2021/08/17/arbitrage/