The Arbitrage Triangle by Denomics

Ok time to move onto Part 2 of the “How to trade the crypto market series”, this one might cook your brain a little, but please take the time to read it a few times if the math is confusing.

What is an Arbitrage triangle?

An arbitrage triangle is a result of a discrepancy between three different assets that corelate together in a specific market. A really easy break down to understand the triangle is to use basic items you’re familiar with and figures easy to understand, so lets make an example below.

Lets say we are at a farmers market
Vendor A is offering a swap of 10 oranges for 10 dollars
Vendor B is offering a swap of 10 oranges for 10 apples
Vendor C is offering a swap of 1 Apple for $1.50

This now creates an arbitrage triangle that we can exploit without the prices changing at all. This is a completely different concept to traditional investing/trading using the buy low sell high method, and here is how we do it.

You can go to vendor A with $10, and purchase 10 oranges.
You then go to vender B and swap your 10 oranges for 10 apples.
Then go to vender C and swap your 10 apples for $15.
Congratulations you just made 50% profit

Now you can go back to vendor A, swap $15 for 15 oranges, and simply rinse and repeat this process accumulating more and more each time (this is referred to as compounding) sounds awesome right?.

Well until one of the other vendors runs out of supply (liquidity) and has to change their deal. Vendor C now has a massive supply of apples and no buyers, so naturally the price will drop, lets say to $1.20. Vendor A has run out of supply of oranges so has to raise his price to meet demand let’s say to $12 for 10 oranges. Now it will cost you $12 for 10 oranges which you can still swap for 10 apples to vender B, but you will only get $12 if you sells them to vendor C, netting you no profit and making the whole exercise pointless as there is no spread to exploit.

Starting to understand?
Ok now lets put it into crypto terms so you can see how this plays out in our world.
Let’s say NEO is trading against BTC (NEO/BTC) at 0.001 BTC
and BTC is trading against USD (BTC/USD) at $10,000 USD
but NEO is trading against USD (NEO/USD) at $12 USD ???

This means you can purchase 1 BTC for $10,000, use that 1 BTC to swap for 1000 NEO and then swap that 1000 NEO for $12,000 USD. That’s a 20% gain (spread) from a few clicks of the mouse with out the price even moving. Imagine doing this with 1 million dollars? It would be the quickest 200k you have ever made right?.

Well just like our farmers market example, that spread will not stay around long. As supply and demand get tighter that spread will get smaller and smaller until the point there is no spread to exploit. These opportunities are hard to spot, happen very fast, are often very small percentages and the only way to take advantage of them is through advanced computer programs we know as bots.

So Grizz why do we need to know this stuff?
Don’t worry we are getting there, this is just one of the pieces to the puzzle you need to understand in order to really grasp the way the crypto market moves and how to trade it. For this next part we are going to look at the correlation of the triangle in crypto.

EXAMPLE 1
Using the original example of NEO above I have created a pretty little graph to make it easier to understand cause lets face it, visual learning is often best. In this example we have a nice stable market and a base to work with, you can see that BTC against USD is $10,000, NEO against BTC is .001BTC there for NEO = $10 against USD.

EXAMPLE 2
Now if the price of bitcoin doubles against USD, and the Price of NEO against BTC does not move (sat price), then price of NEO against USD would also double. Why you ask? Ummmm go back to the start of this article and understand both correlation and the arbitrage triangle again, the system doesn’t allow us to print money for free for very long so they will move together FULL STOP.

EXAMPLE 3
Now what if the SAT price of NEO halves during this time? well what do you think? The USD value is a by product of the price of NEO against BTC and the price of BTC against USD. There for it would also halve because even though BTC is worth twice as much…you now have half as much of it (hold onto your Sats god damn it)

EXAMPLE 4
Now lets say the price of NEO against BTC stayed at .001 how ever the price of bitcoin halved from the original price to $5000, the price of NEO against USD would also half…… what the hell why? Well your still holding the same amount of bitcoin worth of NEO, but your bitcoin is worth half as much…is everything starting to sink in???

EXAMPLE 5
Now lets say the SAT price of NEO doubles now, that means the USD price of NEO would also double.
Do you see how the USD value of the ALTcoins is a by product of the SAT value of the ALT coin and the current price of Bitcoin. There can not be a discrepancy in the 2 trading pairs, other wise it opens up an arbitrage triangle for bots to exploit and print money for free until that gap gets closed, which can happen in milliseconds.

So why is it important you need to know this? Its important you understand how ANY money markets work that your planning to trade, as that is how you find your edge on the market to WIN. You need to understand the correlation of the USD value of your SH!Tcoins to the value of Bitcoin. If you do not grasp this concept, you simply do not understand this market and will continue to throw darts at the board,. You might win in the short term but statistically…you probably wont last the whole game.

Next I launch the final piece to the puzzle and the debatable topic of SATS vs DOLLARS!! I will apologise in advance, because I can get pretty brutal on this subject and a lot of you may cry, when you figure out how many mistakes you have made.

Until then, enjoy the read and I hope you learnt something, peace.