Note: this article outlines theidea of arbitrage and how it works — this article shows you how to leverage Yield Monitor to spot arbitrage opportunities in DeFi.

Arbitrage is generally considered a healthy and beneficial practices as it serves to add liquidity to markets and, in effect, balances out price discrepancies and inefficiencies across markets.

There are a few main types of arbitrage:

Retail Arbitrage
This occurs when stores, or individual resellers, buy large quantities of a popular or highly desired item as soon (and quickly) as possible, and resell it to retail buyers at a much higher price.

Example: new popular toys before the holidays, or toilet paper during COVID lockdowns.

Simple Arbitrage
This is the type of arbitrage we’ll look at in this article. Simple arbitrage involves buying an asset in Market A and selling it for a profit in Market B. This also includes arbitrage using multiple currencies, known as Triangular Arbitrage.

Merger Arbitrage
As the name suggests, this type arbitrage occurs when investors speculate that a public company is likely to get acquired by another organization. Betting on the acquisition, investors or funds will buy shares of the company to earn profits when the company is acquired for a higher price per share. This type of arbitrage is typically executed with a longer time horizon and can, of course, be riskier due to the complications and often failures of mergers or acquisitions.

An Example: you realize that the price of Bitcoin is $20,125 on Coinbase and $20,155 on Binance. By buying Bitcoin on Coinbase and selling it on Binance, you’ve taken advantage of this price discrepancy, and made a profit. This is arbitrage. This can also be accomplished in a non-digital setting, too.

Another Example: you realize that Vendor A is selling gold bullion for $1,000 an ounce, but you know Vendor B is buying gold bullion for $1,085 an ounce. An arbitrageur would buy as much gold bullion as possible from Vendor A and sell it to Vendor B to make a profit on the price difference. This could be executed for any type of asset or object of value.

There are more complex opportunities in arbitrage, too. For example, adding more assets or commodities in the trading strategy helps traders spot and capitalize upon potential opportunities.

A simple example could be trading USD to Swiss Francs to Canadian Dollars, then back to USD. Let’s use a hypothetical set of numbers to illustrate this scenario:

USD to Swiss Francs: $1.25
Swiss Francs to Canadian Dollars: $1.55
Canadian Dollars to USD: $2.15

Note that this example is entirely hypothetical and for illustrative purposes only.

Let’s assume you have $100,000 of capital to deploy in this arbitrage opportunity. In this scenario, you would make the following trades:

Sell USD to buy Swiss Francs: $100.000 / $1.25 = $80,000
Sell Swiss Francs to Canadian Dollars: $80,000 / $1.55 = $51,612.90
Sell Canadian Collars back to USD: $51,612.90 x $2.15 = $110,967.73

To calculate your profit, simply subtract your initial capital from the final amount.

$110,967.73 – $100,000 = $10,967.73

In this hypothetical scenario, you’ve made $10,967.73 via arbitrage. Note that this does not account for transaction fees or taxes.

Given the growing levels of technical efficiencies across markets, arbitrage requires fast-acting trades to capitalize on price discrepancies, which are often short lived. Many investors and automated investment algorithms are dedicated to finding and exploiting potential arbitrage opportunities.

In today’s highly technical markets, arbitrage opportunities may present themselves and be exploited in a matter of seconds. Trading activity, access to the market or asset, and available liquidity impact how large — and how available — the arbitrage opportunity may be.

In the context of basic Decentralized Finance (DeFi) trading activity, retail investors should keep a few elements in mind before making trades:

The Size of the Price Discrepancy

Consider the amount of opportunity available in this situation. Is the price difference between an asset on different markets particularly large? It’s probably not worth your time and effort if you’re only going to profit a few dollars in a trade. Additionally, available liquidity plays an important role: if you’re trading assets with limited liquidity, you’re likely going to experience significant slippage which may result in an unprofitable outcome.

The Size of Your Position

How much of an asset will you need to buy and sell? Keeping in mind that, at all times, other traders (and automated investment algorithms) are seeking arbitrage opportunities, too. You should not be committing a large portion of your capital to exploit an arbitrage opportunity, especially if the risk-reward is not worth the effort or the capital.

The Gas to Migrate Funds

As a DeFi investor, you’re already familiar with how blockchains work, and the gas fees associated with moving funds into various protocols. If you’ve found an arbitrage opportunity that will net you $50, but the gas fees are going to cost $15, you may determine this trade is not worth your time, especially when combined with other considerations.

The Trading Fees

Depending on the protocol or platform you’re using, you’re going to incur some kind of trading fee. Centralized exchanges may charge more than some Decentralized Exchanges (DEXs) and that may impact your decision making. Additionally, keep in mind that available liquidity may prevent you from selling your entire amount of the asset at the desired sell price. If you need to migrate funds to various markets to sell your position, these fees will cut into your potential profits.

Tax Implications

Based on your location and jurisdiction, you’re likely going to be required to pay taxes on your potential profits based on this trade. Assets traded or sold within shorter time frames, for example, are typically taxed at a higher rate than assets held over the long term.

For example, US-based investors must stay mindful of short- and long-term capital gains taxes. This topic can add complexity and nuance to your decision making process.