Financial investing comes with a wide range of strategies you can employ to generate a profit. That is also the case with trading bitcoin. In this article, we discuss bitcoin arbitrage and whether or not this strategy is a smart way to invest in bitcoin.
In financial investing, arbitrage refers to the simultaneous buying and selling of the same asset or security on different exchanges to profit from price differentials on these exchanges.
For example, if the price of an asset is trading at $100 on exchange A and at $98 on exchange B, an investor can purchase the asset for $98 on exchange B and then immediately sell it for $100 on exchange A to generate an effectively risk-free profit of $2. This is the concept of arbitrage trading.
Arbitrage trading is actually what keeps the prices of securities and assets roughly the same on all exchanges because if a price differential occurs on one exchange versus another, someone will come in and capitalize on it immediately. In the stock markets today, this is done using high-frequency trading algorithms that seek out arbitrage opportunities and execute the trades automatically.
Bitcoin is a fairly liquid asset since it is still maturing into a mainstream asset class. This, in turn, makes it easier to find price differential on different exchanges.
When looking at theBTC/USD priceson five of the biggest bitcoin exchanges, you can see that there are quite substantial price differentials. During the time of writing this article, the price of BTC/USD stood at $2,355.22 on BitStamp, at $2,363.65 on GDAX, at $2356.08 on Gemini, at $2,346.00 on Kraken, and at $2,312.50 on Bitfinex. This shows that there is a $51.15 dollar price differential between the highest and the lowest bitcoin price on two of the largest bitcoin exchanges.
Given these figures, if an arbitrage trader purchases 100 BTC at $2,312.50 and sells 100 BTC at $2,363.65, he or she could bank a profit of $5,115.00 (minus trading fees).
While the above-mentioned price differentials might sound like an arbitrage traders dream, the reality is that there are several challenges that make bitcoin arbitrage trading more difficult and less profitable than shown in the example above.
Firstly, to generate a profit with arbitrage trading, you need to trade large volumes. 100 BTC, for example, right now equates to around $250,000. So, for the above-mentioned trade to happen, you would need to buy and sell $250,000 worth of bitcoins at the same time, for around $5,000 of profit. That is a lot of capital at risk for a small profit.
Secondly, trading fees and transaction fees will reduce your profits. Most bitcoin exchanges charge fees per trade executed, usually 0.2 percent of each trade or more. Exchanges also charge withdrawal fees, which need to be taken into account. So, each arbitrage trade needs to generate more profit than the attached transaction fees you incur on both exchanges. In the above-mentioned example, the profit equates to around 1 percent of the capital at risk but now the 0.2 percent trading fee needs to be taken off plus the withdrawal fees, which can be another 0.1 percent or more on both sides of the transaction.
Thirdly, storing large amounts of bitcoins on exchanges is never a good idea since bitcoin exchanges are regularly targeted by hackers who try to steal digital currency deposited on exchanges. This makes bitcoin arbitrage a rather risky venture.
For these three reasons, bitcoin arbitrage is not a recommended investment strategy. The risk-free aspect of making arbitrage trading profits are not so risk-free at all when trading bitcoin. The bitcoin trading ecosystem is simply not developed enough for quick and easy arbitrage profits to be made.
Furthermore, this strategy involves constant monitoring of bitcoin prices and is, therefore, not suitable for everyday investors who do not have the time to stare at a computer screen all day. The simple buy and hold approach to bitcoin investing is much easier and will most likely also be more profitable in the long run.
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Alex Lielacher is a former bond trader who now writes about bitcoin and blockchain technology. He holds a degree in Investment & Financial Risk Management from Cass Business School in London and has been following bitcoin since 2011.
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