Exchange arbitrage inventory risk

I’m a bit confused about how arbitrage systems account for inventory risk when working across two exchanges. This is probably best explained with an example.

Imagine you are trying to do BTC/USD arbitrage on Exchange A and Exchange B.

  1. You have starting capital of $40,000 and the current BTC/USD price is $10,000.

  2. To set up for arbitrage, you place $10,000 and 1 BTC into your accounts on each exchange. Your total capital is now $20,000USD and 2 BTC.

  3. An arbitrage opportunity presents itself where the BTC/USD price on Exchange A is $10,000 and $10,100 on exchange B. You buy 1 BTC on exchange A and sell 1 BTC on exchange B. This leaves you with balances of $0 and 2 BTC on exchange A and $20,100 and 0 BTC on exchange B. So now your total capital is $20,100 and 2 BTC, so you have made a profit of $100 and have the same number of BTC!

  4. Here is what I don’t understand…now imagine in Bitcoin tanks from $10k to $5k. Even though you have made $100 profit on the arbitrage trades, your total capital is now worth $30,100 down from a start of $40,000. So… if you run this system are you basically counting on BTC price going up over time? How else can you avoid this inventory risk? Do you just keep your 2 BTC inventory as basically a permanent inventory?

Big disclaimer: I’m not interested in if arbitrage opportunities exist in crypto in 2020…I understand it isn’t 2016 anymore. I’m really just curious about the theory. This is more of a “shower thought” post than a “I am currently writing a bot around this strategy” post. Thanks guys!

Submitted October 30, 2020 at 10:28AM by u2m4c6

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