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How to stop failing at Arbitrage

by Steve Shelton

Admit it, when it comes to your favorite exchange, you’ve been unfaithful. You checked prices on random pairs across multiple exchanges, noticed the spread, seized the opportunity and… failed?

For many, this has been a source of endless fascination because over the past year as the markets have taken such significant downturns, arbitrage trading opportunities have presented themselves as the major source of income for savvy traders.

Why is this?

Done properly, Arbitrage, the act of buying low in one place and selling high in another, is one of the most powerful weapons in a trader’s arsenal.

If you’re like most people, you’ve tried it a couple of times, got burned and walked away.

It isn’t that arbitrage doesn’t work. However just like chart patterns, signals, indicators and leveraged trading, it is a tool that requires knowledge and skill to execute properly and most successful arbitrage traders are too busy making money to share their secrets. Arbitrage is one of the few places where an individual player benefits from having fewer people in the market not more. Of course good arbitrage traders are loathe to share their secrets.

Why am I going to share my secrets with you? Because I’m tired of seeing misinformed articles from newbies who attempted it for awhile, fail and suddenly declare that it isn’t possible. For me the word “impossible”, is more of a challenge to prove you wrong, than a statement of fact.

But don’t despair, it is not impossible to profit from arbitrage. You’ve just been doing it wrong. Not because you’re too dumb, but because success here doesn’t work the way you think it does.

Even though arbitrage can be successful, you can’t just buy low in one place, transfer to another place, sell and repeat. This doesn’t really work that way.

Let’s go back to basics to understand why…

Success in finance is always predicated on the 3 Rs.

  • Right time
  • Right place
  • Resources sufficient to take advantage

You need the three Rs in place before you even begin. Without those three in place you will fail, every time.

Rule #1: Windows really open, but they might not be clear.

There are always candles with a price difference between exchanges and there are always spreads between bid and ask that are way outside the close of the last candle. This is what markets do.
Within every exchange and between exchanges, it is drop dead simple to think these are signals.
But you are wrong. What you need are not candles, and especially avoid looking at lowest bids on exchange A and highest asks on exchange B.
In fact, you need lowest ask on A and highest bid on B. Even better, pull in the entire orderbook and consolidate it to the dollar level or the ten dollar level. This will show you if there is any depth or if it is just a fluke.
Without that, there is no window. Sadly if you go to github and download a price hunting bot, 99% of these things get that bid / ask spread backwards and end up showing 80% spreads, when in fact it is inverted and you’ll take a loss just by jumping in. So before you jump in, double check that you are really looking at a low ask and a high bid. Don’t be in a rush. A window that opens, tends to follow a pattern, the first 5 minutes is 10 to 20% of the spread, then it jumps to 80% and begins closing over the space of an hour. Yet there are always windows opening up somewhere. So don’t hunt them down, just verify they’re really there before jumping in.

Rule #2: Never ever attempt arbitrage at an exchange you don’t have experience day trading on.

I mean think about it. What makes you think you can sign up for a new exchange you’ve never used before, perhaps in a language you don’t even speak and suddenly become a pro at their UI?
If this is an exchange you never heard of before, how do you know you can trust them? Do you know what their fees look like? Are they charging deposit fees, withdrawal fees, trading fees? What about order cancel fees?

Yet that’s exactly what most people who fail at this do. They see an opportunity on an exchange they don’t yet trade with, hurry up, open an account and throw their magic internet money money at complete strangers.
There’s typically a good reason a window opens. Everyone else has access to the same data that you do and no one likes to lose money. If there is a difference in pricing between exchanges there’s a reason for it, like wallet maintenance and you’re not likely to find that reason until you slam into it in the middle of your trading.

Rule #3: If you don’t know what it is, don’t trade it…

If you’re buying something you’ve never even heard of, I can promise you that you’re about to step into an open elevator shaft. If you have a bot automating your picks, you’re just asking to step into multiple open elevator shafts a day.
The truth is that buying a random alt is almost always a money losing strategy.

These thinly traded alts can and frequently do have spreads of 200 – 300% on the places where they trade, but it is because the volume stinks.
Sure that crapcoin might have doubled, but doubled from what? Does going from 1 satoshi to 2 satoshi on 1000 satoshis of daily volume really count as doubling?

Charts lie, they show you only the last trade and perhaps a recent bid and ask if you’re lucky.
At a minimum you need to take into account more than the last price, you need full pricing data and the full order-book.
These things take time to account for. So cool your jets, there is always another opportunity about to come up in a pair you do understand. In the meantime do your homework and try to figure out why that coin is doing whatever it is doing.

Rule #4: Always calculate the real cost before entering any position, and double it for arbitrage.

An example of this is BTC/USD on Bitstamp vs Bitfinex. Volume is clearly not a problem for these exchanges especially on BTC/USD, so why is Bitstamp almost always lower and Bitfinex always higher?
The truth is, when you see exchanges that spend days or weeks with a significant open window between their pairs and they have roughly similar volume, it is almost always because of the fees.

Exchanges are a business. As a business they are obligated to earn money. They have a lot of costs to cover. A single wallet server costs hundreds of dollars per month, now multiply that by all the currencies they carry and you can see why exchanges come and go so quickly. They need to earn their money, they need to earn it from you, just accept it.

Most exchanges charge fees on deposits, withdrawals and trading, some charge fees on order cancellations as well.
Furthermore and this isn’t unique to arbitrage trading, but there are also network fees that almost every crypto charges in order to limit network spam and these eat into profits.
This gets especially dangerous if fees are a variable cost that scale upwards with demand, ETH I’m looking at you grr

An exchange with higher trading fees is going to have a greater spread between bid and ask because traders need to make money as well and if you’re paying when you buy and paying when you sell, those costs need to be accounted for in your trades or you’ll lose money.

Here’s an example…

Current BTC price is $3800 on Polo and $3900 on Bittrex.

So if we buy 1 BTC on Polo and sell it on Bittrex we stand to make $100 USD right? Not so fast..

Poloniex charges a maker fee of 0.1% and 0.2% on taker fees, Bittrex charges a flat fee of 0.25%
Bittrex also charges a withdrawal fee of 0.001%, Polo charges a fee that depends on the coin, but seems to be a flat minimum plus about 0.0005% of the transfer amount.

So to get the 1 BTC we’re going to pay $3807.60.
Next we need to withdraw it, this is going to cost us 0.0005 BTC which really means we’re only going to get 0.9995 BTC at Bittrex. We transfer it, but by the time it arrives at least an hour has passed and the price on Bittrex is now $3820 because a lot of people are doing exactly what you’re doing, being a mule. Which means by the time it arrives and we get it into the market we only get $3818. Still a small profit, but Bittrex is going to take $9.54 of that leaving us with $3808.
Congratulations you made a successful arbitrage trade, for all that time and effort, we’re up only $0.40, hardly seems worth it doesn’t it?

When considering finance a lot people talk about the Time Value of Money, but almost no one talks about the money value of time.

Was $0.40 USD really worth the hour minimum you just spent? Your time has real value, to you, to your friends, your family, your employer. Don’t waste it!

To make this really happen we would have needed to move 100 BTC or more at a time. Yet here’s the truth, almost no one is playing with 100 BTC on a single arbitrage play.

So what’s their secret?

Again it boils down to the 3 Rs. In order to benefit from arbitrage you need to be in a position to do so ahead of time.
If you’re rushing into the market as the window opens, you’ll lose money or at best break even 100% of the time.

Instead you need to do what the pros do.

What Professionals Do.

1. Get the places you’re going to trade at really dialed in. Pick the exchanges you like because you like them. Don’t give strangers your money.

Go through their whole AML/KYC compliance process and get fully verified before you give them a single satoshi.
If you don’t do this then you’ll find your account locked out at the most inopportune times. Give them your details while they don’t have ANY of your money and there’s no risk of them going poof with it.

2. Pick pairs you really like. I love pairs with high volume that have significant depth in their order books. BTC/USD, ETH/USD and LTC/USD are my favorites because they tend to have the deepest books and the most active markets. You’re far less likely to step into an open elevator shaft with those. No one wants to be a bag holder. Most importantly, understand what it is you’re trading. If you know nothing about the coin and are just trading it because it happens to be heading upwards, you’re taking on a horrible risk of being the bag holder at the end of a pump and dump. Know the coin, know the community, even consider getting involved with the community while waiting for your orders to fill. By being involved in the community and active, you’ll be privy to early information that few others have and this early information can make the difference between having a successful growing portfolio and being stuck with ever growing sacks full of someone else’s scamcoin.

3. Day Trade with a winning strategy. Everyone has their favorite. I examine trends across multiple time frames and use a combination of RSI and Bollinger Bands to help me price my entry and exit into the market, and then I have a bot that monitors my positions so I can have a life instead of waiting with balled fists and clenched teeth staring at charts all day. This means I do about an hour or two of research a day, set my entry and exit points and spend the rest of the day living my life. This isn’t an arbitrage strategy per se, but that’s because arbitrage should never be a primary strategy. Arbitrage is meant to supplement an existing strategy.

When you do it this way, Arbitrage is actually a lot simpler than you think. It becomes a supplement to what you’re already doing and an effortless one at that. Simply get in position on the exchanges you like, with the pairs that you like using the strategy you like. When a window opens up, do your buy and sell on both exchanges at the same time, but avoid transferring. Do this as often as funds allow and opportunities present themselves. At the end of the day or the next morning, you’ll have a discrepancy between accounts. Just send a single transfer to balance things out.

But what about bots that can scan all exchanges and all pairs? What if I buy/build one of those? Can’t I just take have the bot take advantage of the spread between BTC/SOMETHING on exchange #1 and #2?

Rule #0: Bots are evil and cannot be trusted.

The answer is, “Sure you can, and as a result your bot will automate your account towards a $0 balance in short order.”
The long answer is that bots don’t make money, strategies do. Bots can only automate a strategy. If the strategy tends to lose money even slowly, the bot will find new and interesting ways to lose money quickly.
That isn’t to say all bots are bad. I personally use a bot to detect when the best bid drops below the 24hr low and have it sweep my entire account to cash. This keeps the account from following the coin off a cliff and preserves value. This way I live long enough to play another day. But even that simple strategy has had a handful of times where the bot made the wrong decision and in retrospect I would have been better falling off the cliff because the bounce was so high.
But as long as the strategy wins at 51% of the time, you’re still making money and that’s where bots do shine. If your strategy is correct at least 51% of the time, all other things being equal, your bot will earn money for you.

That’s all there is to it.

In Summary

Arbitrage is really quite simple and powerful, but should be a supplemental strategy, not a primary one.
Adding arbitrage to an already successful strategy can more than double your daily trading profits, why?

Because you’ve covered all three Rs:

  • Right Time: When spreads open, you’re already there helping to close it before the mules arrive.
  • Right Place: Because you’re familiar with both exchanges and they frequently have spreads between them, you know it’s coming and you were there waiting.
  • Resources Sufficient To Take Advantage: You’ve been trading awhile and you’ve been successful in your primary strategy, meaning you have the resources to buy low on A and sell high on B without endangering your overall portfolio and this is the real secret of all successful traders.

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