How Does Market Liquidity Affect the Profitability of Arbitrage Strategies?

Market liquidity is crucial for the profitability of arbitrage strategies. In a highly liquid market, it is easier to execute large trades quickly and with minimal price impact (slippage), which is essential for capturing small price discrepancies.

In illiquid markets, the act of executing the arbitrage trade itself can move the price, eliminating the profit opportunity before it can be fully realized. Therefore, arbitrage opportunities are often more fleeting and less profitable in illiquid markets.

High liquidity allows arbitrageurs to deploy more capital and capture smaller, more frequent opportunities, while low liquidity restricts the size and frequency of these trades.