What is Arbitrage?

in Project HOPE16 days ago

This article was originally written by me and published on the Hummingbot Blog

Welcome to Hummingbot Academy!

Last week we published the first article of the Hummingbot Academy, covering an introduction to what is Market Making, and today we discuss Arbitrage in order to answer the following questions:

  • What is arbitrage?
  • What do arbitrageurs do?
  • How to run arbitrage operations?
  • How do I create my arbitrage robot?

Here at Hummingbot Academy our goal is to help you learn more about market making and arbitrage, and how to use our free open-source robot to implement your own strategy.

But what is arbitrage?

The concept of arbitrage is pretty simple:

Arbitrage is the purchase and sale of an asset in order to profit from a difference in the asset's price between markets.

To better explain exactly how an arbitrage operation happens, let's talk about bananas. Yes, bananas.

image.png

Photo by Adam Jones adamjones.freeservers.com

Picture a small town, where a big part of its economy is based on bananas production, with a lot of farms selling their crop on the local market.

This result in a lot of bananas being sold locally, and naturally due to the high offer, they are pretty cheap to buy, let's say for $0.50/kg.

A few kilometers away lies a big city, but most of its economy is based on industry, therefore there aren't many banana farms surrounding it.

But citizens of that big city still want to eat fruit to have good health, which creates a big demand for bananas, and they are willing to pay $0.65/kg.

It's pretty clear to see there is an opportunity here, and a merchant could buy bananas from the small town, sell on the big city, and profit $0.15 (without accounting the transportation costs) for each transported kilogram.

The merchant (arbitrageur) in this case is doing an arbitrage operation: buying and transporting bananas (the asset) from one market and selling it on another market for a profit, while reducing his risk by locking his profits if both sides of the deal are closed at the same time.

Isn't it the same as a market making operation?

Although the basic concept of both operations is pretty similar (buy low and sell high with a small profit margin), the key difference is the 'where' the market maker and the arbitrageur look for deals.

The market maker (like a pawnshop owner) operates on a single place, making buy and sell offers on the same market.
The arbitrageur (like a merchant transporting goods between towns), operates on more than one place, taking buy and sell ****offers from two (or more) different markets.

The way each one affects the markets is also different because while a market maker is providing liquidity, reducing bid-ask spread and slippage, while the arbitrageur is removing liquidity from two markets (usually from a high-liquidity market and a low-liquidity market), but pushing the prices to converge on the same level on both places.

Markets inefficiencies and arbitrage on financial markets

(To keep reading this article visit the Hummingbot blog).

Sort:  

Thank you for sharing this content where you show us the mechanisms of the banana market and how supply and demand behaves according to its price in the competitive market.

Good contribution, in my country it is known as an intermediary and the truth is that there are many who raise the price of things and earn more than the producers.

@tipu curate

Upvoted 👌 (Mana: 0/45)