How is an arbitrage opportunity calculated?

The arbitrage opportunity for any market is calculated by identifying the overlap between the highest bid prices and the lowest ask prices. When the bid price on one exchange is higher than the ask price on another exchange for a cryptocurrency, this is an arbitrage opportunity.

Now, before we start throwing trades at this situation hoping for a quick buck, let’s take a measured approach by calculating the size of the opportunity. One thing we need to remember when calculating the value of the arbitrage opportunity: Executing the arbitrage will result in consuming the order book. For example, let’s look at “Step 2” in the illustration to the left. In this step, we have highlighted the amount of the order book which overlaps. That means the bid price on one exchange is higher or equal to the ask price on another exchange for the highlighted area.

However, once we begin executing on the arbitrage opportunity, what we notice in steps 4 and 5 is that consuming the order book results in the arbitrage opportunity shrinking after each price value is taken. Therefore, we aren’t able to capitalize on all of the value which is highlighted in yellow in step 2 (the area of the depth), but only a fraction of the value.

When calculating the size of the opportunity, we must therefore take this behavior into account. We can do this by systematically simulating the execution of the actual buys and sells we would actually make on the exchange during the arbitrage.

How are trades executed to take advantage of the arbitrage opportunity?

Now that we understand conceptually how arbitrage happens, let’s discuss the most popular types of arbitrage opportunities: Simple and Triangular Arbitrage.

Simple Arbitrage

Simple arbitrage is the buying and selling action we described in our previous examples in this article. Simple arbitrage buys and sells the same crypto asset on different exchanges as quickly as possible to take advantage of the inefficiencies of pricing across exchanges.

This form of arbitrage does not require any additional trades outside those necessary to swap the two assets which are shared by the asset pair which is exhibiting the arbitrage opportunity.

Triangular Arbitrage

Triangular arbitrage is an event that can occur on a single exchange (or across multiple exchanges) where the price differences between three different cryptocurrencies lead to an arbitrage opportunity. Since many exchanges have a number of markets with a variety of quote currency options. This opens up a long list of triangular trading patterns that can be leveraged to take advantage of inefficiencies in an individual exchange pricing.