One of the ways an investor (in this case an Arbitrager) can make money on an asset is by taking advantage of temporary discrepancies in pricing. One example is discrepancies in exchange rates between currencies. Let’s use a more contemporary example!
Let’s go with cryptocurrencies like Bitcoins, Ethereum, etc.
Discrepancies arise due to supply, driven by the number of sellers and the difficulty in mining a cryptocurrency, and the demand, driven by the number of people who are willing to buy said coins. These factors are always changing and the supply and demand for Bitcoins will not match Ethereum. Some days more people want Bitcoins then Ethereum and vice versa. This leads to situations where for example if I buy $100 worth of Ethereum and then exchange my Ethereum for Bitcoins and then sell the Bitcoins, I’ll walk away with more then the $100 I started with.
In theory this is great! Without having to do anything other then press buttons and make calls, you’ll make a massive profit and overtime become wealthy! Life just went from a small dorm room you share with 3 guys to a luxury condominium and you’re planning on trading that junker for a Porsche! Easy right?
WRONG! in practice there are many factors that will work against you.
One such factor is liquidity, that is how fast you can actually buy a cryptocurrency and exchange it before the exchange discrepancy disappears or moves against you. Discrepancies may also exist due to the difficulty in exchanging cryptocurrencies – some exchanges make up for this by changing hefty premiums. (I’ll go more on this concept in later posts)
The other factor is speed. If there is a discrepancy, keep in mind that you may not be the only one who has figured it out. Discrepancies disappear over time as people begin to trade on that information. This means for example the asymmetric exchange rate you discovered this morning will may be gone come lunchtime – usually much earlier then that. If you cannot make the transactions within that time frame, you’ve lost.
Another factor is exchange rates and premiums. Keep in mind, in the real-world people expect to be paid when you use their exchange service. These fees may not only eat away at your potential profits but even make the act of arbitrage unprofitable.
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Remember this article was written for the intention of entertainment purposes and should not be used as legal or investment advice. Please consult with a financial adviser and an attorney before considering any investments.
The Featured Image was taken from wikicommons: Here