Cryptocurrency arbitrage - still an effective trading strategy
[info_block align="right"]The principle of classical arbitrage is based on making profit from price differences on different markets. [/info_block]
The demand for cryptocurrency is constantly growing, and it is gradually becoming a worthy analogue of official money. At the same time, cryptocurrency as a trading instrument, begins to cause more and more interest among traders, which can't be ignored by the explosive growth of the number of crypto-exchanges and trading turnover.
The market for cryptocurrency exchanges is still quite young, but it is actively developing. The fact that the market is still in its infancy plays into our hands, as it opens up a large number of arbitrage opportunities. Below is the current list of cryptocurrency exchanges, sorted by trading turnover. As we can see, OKCoin is the undisputed leader with 54 thousand daily turnover.
The principle of classical arbitration
No one will argue that the most attractive strategy for trading on the exchange is arbitrage. In its essence, it implies minimal or no risk at all. Thus, even a minimally profitable strategy with sufficient turnover should bring tangible profits.
The principle of classical arbitrage is based on making profit from price differences on different markets. This is a type of so-called spatial arbitrage, where transactions are conducted by representing the same instrument traded on different exchanges. Usually the task is reduced to the banal - to buy cheaper in one place and sell at a higher price in another.
Prices on exchanges differ because of the natural effect of decentralization and the so far underdeveloped market, primarily from a technical point of view - exchanges still operate on rather slow web technologies. As profits are often derived from the inefficiencies of the execution and quote aggregation system itself, classic arbitrage strategies are considered virtually win-win. Of course, we do not take into account the risk of a simple technical error, which can nullify all the advantages.
Arbitrage, long familiar to traders
[info_block align="right"]We buy the catching up currency and sell the leading one, and close the deal when they touch.[/info_block]
This strategy should be familiar to traders in the decentralized market, where there is also no unified market stack. Such method of work allows any broker to give arbitrary quotations, because of which leading and catching up appear naturally, i.e. the price of one and the same instrument can change with a noticeable lag. Naturally, the number of those wishing to "restore justice", i.e. to bring prices at all exchanges to equilibrium, grows, and the difference is gradually equalized, till trading of an instrument loses its economic sense at all.
Unlike ah, crypto exchanges are more like traditional exchanges, because in the end you get real currency in your hands. Since cryptocurrency itself appeared relatively recently, and liquidity on exchanges is still not high enough, arbitrage situations happen much more often than on instruments with higher turnovers. Add to this the problems with reverse conversion of funds, that is, withdrawal back into fiat (official) money, and we get obvious to the naked eye market leaders and outsiders.
Simple Trading Arbitrage Strategy
In fact, the simplest arbitration looks something like this:
- Buying currency 1 for currency 2 at a low price
- Transferring currency 1 to another exchange
- Sell currency 1 for currency 2 at a higher price
- Profit.
Let's set the situation. Let's say the BitStamp exchange rate for BTC/USD is $700 at the moment, and the same pair is $720 on MtGox. Theoretically, buying one bitcoin for $700 on BitStamp, and selling it on MtGox for $720, we would get 20 net profit. Put the dollars back on BitStamp and repeat the whole process from the beginning.
Of course, in the real market the situation is somewhat different, and the calculation should take into account the fees of payment systems and the exchanges themselves, but the principle should be clear.
How an arbitrage strategy breaks down
At the beginning of the exchange, it is this scheme that brings the most profit. Over time, when the number of those wishing to profit from free feed reaches the limit, the difference between the rates is erased. All profits begin to be eaten up by various commissions and restrictions on transactions. Add to this the waiting time for withdrawal of funds, which can be simply frozen, and the arbitrage is almost completely destroyed.
For some time, arbitrage between the two largest cryptocurrency exchanges MtGox and BTC-E has been a very popular topic. The price on mtgox lagged significantly behind that on BTC-E, creating a seemingly ideal situation.
In fact, prolonged arbitrage is quite rare in a highly liquid market. At the end of '13, the spread between exchanges increased by an order of magnitude, but this difference was mostly caused in an artificial way, including restrictions on withdrawals from MtGox.
Statistical arbitration is more flexible
Statistical arbitrage is very different from its classic buddy. In fact, statistical arbitrage has much more in common with ordinary trading strategies based on probability calculations. The main objective is to Identify patterns of price movements of different instruments and use them in trading.
It looks something like this: to begin with, we select a portfolio of dependent instruments, for example, using the coefficient for evaluating dependencies correlations. Then, having a basket of interrelated instruments, we can determine which of them is now undervalued and which is overvalued, and make a sale or buy one or the other instrument.
A particular example of such trading is paired trading, when only two instruments are traded. Although the efficiency of statistical arbitrage is much lower, the strategy itself seems much more flexible than trying to equalize prices on different exchanges. The solution often comes down to creating a market-neutral portfolio whose floating profit chart moves in a certain channel, allowing for risk-free trades on its boundaries.
In theory, statistical arbitrage allows you to build a stable synthetic tool, using dynamic scales for the size of the open positions. The main problem is to find stable inefficiencies. If the relationship is unstable, the chart will quickly drift away and the portfolio will no longer be market neutral.
Statistical arbitrage on various exchanges
And although bitcoin still holds the lead in terms of total liquidity, many consider it to be a highly overheated asset, so you can see an unprecedented variety of different currencies in the market. Surprisingly, the highest demand for OKCoin right now is the LightCoin pair against the Chinese yuan.
At BTC-E the result is more predictable.
This is what a cross-section of the entire market looks like at the moment:
A typical example is the paired arbitrage between Bitcoin and LightCoin. The correlation between Bitcoin and LightCoin, as you can see in the picture below, is high. Thus, the currencies switch places from time to time - leading/catching up. We buy the catching up currency and sell the leading one, and close the trade when they touch.
If we know for sure that the currencies will come to some parity, then it is a transaction without risk as such, since we make a profit anyway. The problem is that the dependence is not constant and most likely this scheme will not always work perfectly. This does not mean that the method itself is wrong, but still such work requires some effort to determine stable patterns.
The disadvantages of statistical arbitration include All the same disadvantages inherent in other trading strategies can be attributed. Here again we are playing with probability. And the probability that the difference between the currencies will remain fixed for a long time or, even worse, start to increase, remains high.
Conclusions that will bear fruit
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While in developed markets arbitrage no longer looks like such an attractive investment, in emerging markets there are still enough inefficiencies available for ordinary traders to trade through.
Trading traditional arbitrage on cryptocurrencies, as happened earlier with om, loses value because of the extra costs. In turn, there are a lot of simple patterns, due to which even primitive trading strategies should show better results compared to the foreign exchange market. In any case, studying the nuances of trading on cryptocurrencies is a promising and forward-looking direction, which is sure to bring its results.