How does Arbitrage help avoid risk in the trading and inefficiencies in the market?
What if I tell you that trading is not risky? Trading with technical analysis involves Charts with multiple lines and patterns; it is challenging to get hold of all the nuances. Moreover, as per a few sources, approx. 4% of traders make a living out of it. So, 96% of traders risk losing their money- such a high risk.
But there is an easy way out, which involves zero risk and a substantial profit if invested tons of money.
Arbitrage is a form of trading that capitalize on the difference in the price of the same stocks/coins/commodity among multiple exchanges.
Let me tell you with an illustration. Suppose you want to buy a packaged food which is a famous product. There are two shops nearby you.
How would you minimize your risk and gain at the same time?
You will explore both shops to check out the price of the product. If there is a difference in rate, you would want to buy a product at a lower price. I know this illustration is simplistic and overly non-technical, but this is a great way to understand Arbitrage.
What if we replace the product with a crypto coin? Suppose you look at the price of X coin on a platform(e.g., Binance Exchange), and the price is $1. Now you glanced upon another platform(e.g., Gemini Exchange) where the price is showing $1.05.
Where do you want to buy the coin? Gemini or Binance. Like you did in that shop, you would buy X coin here at Binance exchange which is 5 cents cheaper per coin. Suppose you bought tons of X and want to sell them immediately without holding it.
You saw the opportunity in the Gemini exchange, where it is 5 cents more expensive to buy. You sell those coins in the Gemini exchange; you will have made a 5% profit on your invested money without any risk.
However, the process is not as simple as I explained. There is a minimal time gap between your two actions, and that price difference may be no more available in that time gap. Further, if you go to any exchange and buy or sell coins, there is always a transaction cost.
So, the net gains may not be 5%, as I indicated, and it would depend on the overall cost of the transaction and price difference.
This form of trading is called Arbitrage; here, you use the price difference between the identical asset on different platforms. You navigate the profit out of that price difference with zero risk.
You buy an asset in one market and simultaneously sell that in another market, thus leading to profit because of the temporary difference in the price of the asset.
Although it looks easy here on paper, time plays an important role. Generally, Exchanges are slow to make such cross transactions. To gain such profit, you will have to buy X coins at one platform and then withdraw them to another platform where X is trading at a higher price. You would then sell X coins at that platform. But by the time you do this, the price difference may no longer be available among those platforms, and you risk negative gains.
Moreover, finding those price differences is a challenging task and it is not possible to find each pair by searching individually.
What if I tell you that there are platforms where you can do such a form of trading without running the risk of such time issues. These platforms are specifically designed for such trading activity. The seamless interface helps to identify the pair where price difference occurs and allows you to make the transactions in just a few clicks. One such platform is Newscrypto.io
Newscrypto is a financial service platform that provides you with more advanced forms of the trading terminal. One of them is Arbitrage. Their professional dashboard allows you to manage arbitrage activity seamlessly.
Why does Arbitrage exist?
Arbitrage exists due to inefficiencies of the market. As traders exploit arbitrage opportunities, these inefficiencies are automatically reduced. Generally, the buying price of an asset is higher than the selling price in any exchange. When a trader exploits this inefficiency, the selling and buying prices converge.
As this occurs on platforms, the electronic trading terminal automatically adjusts the price difference by the buyers’ offers and sellers’ bids.
Types of Arbitrage:
Arbitrage is any opportunity in the price difference. Although there are several types of Arbitrage, the most common arbitrage forms that exist in the market are:
Pure Arbitrage is a trading strategy discussed above. An investor simultaneously buys and sells security/coins in different markets to exploit a price difference.
Merger arbitrage is another type of Arbitrage, a practice primarily seen in events related to the acquisition of public entities by an acquiring entity.
A merger happens when an entity acquires another company through a deal that generally takes time to close through.
The acquiring company announces the acquisition of the target company, and the purchase happens at a price premium to what the target company’s stock is trading during the announcement. Traders who seek to profit from this announcement purchase shares of the target company in the expectation that the current trading price will match the acquisition price once the deal comes through.
However, there are always risks that mergers do not go through for several reasons. Thus it paves the way for traders in both ways if a trader seeks to short the stock when he believes that deal may not go through.
Although there are very low risks associated with Arbitrage, the gains are insignificant for an individual investor if the investment is not huge. Therefore, big institutional investors and hedge funds with a large money basket employ this trading strategy. The gains from such investment are significant enough to run their expenses.
It is an exciting trading activity, and I love doing it once in a while.
Remember, sometimes learning is more interesting that the gains themselves.
Disclaimer: None of the content, in part or whole, articulated here is any financial advice. This article is about personal investment philosophy and a medium to generate awareness in the financial journey. Please consult your financial advisor before making any financial decision.
Apologies for the above disclaimer!
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