Arbitrage

November 21, 2023 - Around 2 mins mins to read

Understanding Arbitrage

Arbitrage refers to a trading strategy that capitalizes on price discrepancies in various markets. These discrepancies arise due to factors like information accessibility, trading tools, transaction costs, and human behavior. For instance, the value of a cryptocurrency may differ across different exchanges.

Arbitrage traders exploit these price differences by purchasing an asset at a lower price in one market and selling it at a higher price in another market. This process helps to enhance market efficiency by reducing price disparities between exchanges. The objective is to ensure that the same asset is priced similarly across different exchanges, preventing prolonged deviations from its fair value and promoting liquidity.

While arbitrage involves minimal price risk, there are other risks to consider. Traders must execute the strategy swiftly and incur trading costs, such as commissions. These costs can be substantial, particularly when trading on multiple exchanges.

Arbitrage can be conducted between two or more markets and with one or more assets. It can be as straightforward as buying Bitcoin at a lower price on one exchange and selling it at a higher price on another exchange. More complex trades, like triangular arbitrage, involve buying and selling three different assets in three different markets.

The emergence of technologies like automated trading has made it more challenging for arbitrage traders to identify opportunities. However, as long as markets remain imperfectly efficient, arbitrage will continue to play a crucial role in enhancing market efficiency.