There are a variety of approaches you can use when dealing with alternative investing. Such approaches are typically more intricate than the more common “buy and hold” methods used by long-term stock and bond investors in digital asset.
When implemented by a savvy investor, arbitrage can be a highly lucrative alternative investment technique. You should also be aware of the risks involved. As with any alternative investment approach, knowing the ins and outs of arbitrage trading in crypto is crucial for success.
How Do You Define Arbitrage?
Arbitrage refers to the practice of buying and selling the same asset in several marketplaces at the same time to make a profit from minute changes in the prices of those assets. It takes advantage of temporary differences in the cost of otherwise equivalent financial securities in various exchanges and incarnations. The existence of arbitrage is a direct result of market inefficiencies, which it simultaneously takes advantage of and helps correct.
It is a method of financial management in which an investor makes simultaneous purchases and sales of cryptocurrency in several different markets to capitalize on variations in price and produce a profit. Although the changes in price are often minimal and only last for a short period of time, the profits can be significant when compounded by a substantial volume. Arbitrage is a strategy that is frequently utilized by hedge funds and other types of skilled investment.
Arbitration can take many forms, including pure arbitrage, merger arbitrage, and convertible arbitrage, to name just a few. Global macro is an additional investment strategy that is like arbitrage, but it is a different method because it relates to investing in the economic changes that occur between different countries.
What is the logic behind arbitrage trading?
The success of an arbitrage crypto trader hinges on his or her ability to take advantage of price discrepancies between marketplaces for a given asset. To capitalize on the fleeting nature of arbitrage opportunities, most traders rely on computational tools. Let’s have a look at a concrete example to see how stock market arbitrage functions. For the sake of argument, let’s say stock XYZ is traded on both the NYSE and the NASDAQ.
On the NYSE, the price of XYZ is listed in US dollars, but on the NSE, it is listed in Indian rupees. XYZ is trading at $4 per share on the New York Stock Exchange. This company’s stock is currently trading at Rs 238 on the National Stock Exchange. Shares of XYZ on the NYSE would cost Rs 240 if the USD/INR exchange rate was Rs 60. As such, the same stock is being offered for USD$240 on the NYSE and INR$240 on the National Stock Exchange (NSE).
An investor could profit from the arbitrage situation by purchasing XYZ shares at Rs 238 on the NSE and then selling them at Rs 240 on the NYSE. Before engaging in arbitrage transactions, investors must weigh the potential benefits against the potential drawbacks. The favourable pricing difference is due to the ever-changing currency rate.
The risk of loss increases if the crypto exchange rate fluctuates significantly while the trade is being completed. Transaction fees should also be considered. If the transaction fee is more than Rs 2 per share, then the savings from the price difference will be lost.
A Matter of Pure Chance
For the sake of clarity, let’s call the investment strategy “pure arbitrage”—when an investor buys and sells the same security in various markets at the same time to take advantage of a price differential. Therefore “pure arbitrage”, and “arbitrage” are often used synonymously.
Many investments are tradeable in many markets. It’s conceivable for prices to diverge momentarily whenever a given asset is traded on more than one exchange. When this kind of pricing differential prevails, a situation known as “pure arbitrage” can arise.
When fluctuations in foreign exchange rates cause price differences, even slight ones, pure arbitrage becomes an option.
Pure arbitrage, in the end, refers to a method by which an investor takes advantage of market inefficiencies. It used to be easier to take advantage of these situations, but as time has gone on and trading crypto has become more digitalized, mistakes in pricing have been quickly recognized and corrected. As a result, opportunities for undiluted arbitrage are becoming scarce.
Acquisitions and Mergers as an Example of Arbitrage
A situation known as “merger arbitrage” can arise when two publicly traded companies decide to merge.
Typically, a merger involves two companies: the acquirer and the acquired. If the firm to be acquired is publicly traded, the acquiring company will need to buy all the outstanding shares of the target company.
Most of the time, this occurs at a higher price than the stock is trading at the time of the announcement, resulting in a gain for the stock’s owners. Shares of the target firm are bought up by crypto traders anticipating a profit from the deal as news of it spreads, bringing the stock price ever closer to the reported offer price.
Oftentimes, the target firm trades at a discount compared to the deal price. This is because there is always the chance that the deal won’t go through. There are several factors that can lead to a deal’s failure, such as shifting market conditions or opposition from regulatory authorities.
One definition of merger arbitrage is an investor buying shares of the target firm at a discount and then making a profit after the deal closes. Merger arbitrage, however, comes in a variety of flavours. Shorting the stock of a target firm is one strategy for investors who anticipate that a deal will not go through.
Exchange Rate Conversion Arbitrage
Convertible bonds (also known as convertible notes or convertible debt): Convertible arbitrage can occur when party to the transaction has the option to convert the bond into another type of bond.
A convertible bond is a type of corporate debt that provides the bondholder with interest payments. Convertible bonds are a type of bond that gives the bondholder the option, usually at a discount, to convert the bond into shares of the underlying firm at a future date. To attract investors with more attractive interest rates, several companies issue convertible bonds.
Convertible arbitrage is when an investor attempts to profit from the spread between the conversion price of a bond and the market price of the underlying crypto trading shares of a firm. To do this, it is common to hold both long and short positions in the convertible note and the underlying shares of the corporation.
Whether or not the investor considers the bond to be properly priced determines the nature of the positions taken and the mix of purchases and sales. When they believe a bond to be inexpensive, they will typically short the corresponding stock while buying the bond. If an investor thinks a bond is overpriced or rich, they may choose to short the bond and go long on the company for opening hours markets.
The Bottom Line
Arbitrage’s numerous forms can help investors earn low risk returns. Due to low yield, arbitrage requires large volumes to earn enough profit to cover transaction expenses. Arbitrage trading in crypto isn’t a tactic regular investor can use. Hedge funds and other high-volume investors use it. Arbitrage is one alternative investment tool among several. If you’re seeking a career in alternative investments, you should know your options.
