Arbitrage is a strategy used to profit from the differences in prices of the same assets in different markets. It involves buying an asset at a lower price in one market and then simultaneously selling it in a different market where its price is higher.
Traders who apply this strategy are known as arbitrageurs. Arbitrage occurs due to assets mispricing. Arbitrage opportunities should be acted upon quickly. This is because when discovered, the opportunities are quickly eliminated. Arbitrage helps in promoting market efficiency as it minimizes the differences in prices of similar assets.
Example of Arbitrage
The stock of company A in the London Stock Exchange is trading at $30. However, the same stock is trading at $31 on the New York Stock Exchange at the same time. An arbitrageur will purchase the stock in the London Stock Exchange at $30 and immediately sell the stock at $31 in the New York Stock Exchange. This earns the arbitrageur a profit of $1 per share. This strategy can continue until LSE or NYSE identify the opportunity and remove it.
Conditions for Arbitrage to Occur
- The same assets being traded at different prices in different markets.
- Low or no transaction costs when purchasing and selling the assets in different markets.
- Low transaction costs when exchanging currency to trade the assets.
- Different prices are used when trading assets with similar cash flows.
- Assets that have a known future price being traded currently at a price that is different from the expected future cash flows.
Types of Arbitrage
This is where arbitrage is applied when trading retail products. For example;
You buy a crate of goods containing 20 items for $800. Then you sell each item at $50 and end up making $1000 ($50*20=$1000). This earns you a $200 profit ($1000-$800=$200).
Another example is purchasing retail products at lower prices and then selling them at higher prices on online platforms to make a profit.
This kind of arbitrage takes advantage of the market inefficiencies whereby similar assets are traded for different prices in different markets. When applied, the arbitrageur has the potential to profit from the trade. A great example is the one at the introduction of this article with the stock of company A being traded at a lower price in the London Stock Exchange (LSE) and a higher price in the New York Stock Exchange (NYSE).
A second example is when silver is traded in both the Tokyo Stock Exchange (TYO) and Toronto Stock Exchange (TSX). If the silver price in TYO is being traded at a cheaper price than TSX, an arbitrageur would buy silver in the TYO and sell it in the TSX at a higher price to gain profit.
Triangular arbitrage is a strategy where arbitrageurs trade 3 currencies where a currency may be undervalued or overvalued to other currencies. Banks are also involved in this strategy.
In this strategy, an arbitrageur converts a currency in the first bank to another currency, then converts the second currency for another currency in the second bank, and finally converts the third currency to the original first currency in the third bank. The aim is to make a profit from the original amount by converting it into different currencies and then finally converting it to the original currency.
This strategy uses complex formulas to find arbitrage opportunities among financial instruments with different prices in different markets.
Latency is the time taken for your trading instructions to be received and executed by the relevant trading brokers. Latency arbitrage is a strategy that takes advantage of latency as a way to profit. Due to differences in latency, some traders or firms may receive trading information earlier than other participants. This leads to the high-frequency traders getting the best prices in their trades to the disadvantage of slow trading traders. This type of latency occurs when arbitrageurs buy and sell assets and make profits due to the advantage they have regarding latency.
Hedge arbitrage is a strategy where price quotes of assets are compared between brokers. When a difference in prices occurs, that is the time to enter a trade. For example;
You are comparing prices between 2 brokers. Broker X and Y. If the price of an asset offered by broker X is lower than the price offered by broker Y, you open a buy order with broker X and a sell order with broker Y. In this case, you make a profit when you close the orders.
Interest Rate Arbitrage
This is a strategy used by investors who take advantage of the differences in interest rates among currencies to gain profits. For example, interest rates offered by Japan are low. An investor will buy the Japanese Yen and then deposit and convert the money into a currency of a country with higher interest rates to make a profit.
Advantages of Arbitrage
It Promotes market efficiency.
Arbitrage opportunities occur when the same assets are traded at different prices in various markets. As a result, the analysts managing the markets will work towards eliminating the arbitrage opportunity by converging the prices of similar assets.
In this way market efficiency is enhanced by having the same assets with similar prices in different markets. This prevents the prices from deviating from one another.
Profits from arbitrage are considered risk free because the differences in
asset prices in different markets are known in advance. Hence, you can buy an asset at a known lower price and sell it at a known higher price in a different market. It is not like in the buying and selling of shares where you are not sure whether you will profit or not.
Disadvantages of Arbitrage
Sometimes arbitraging leads to losses for the trader. The transaction costs involved when buying and selling assets in different markets, plus costs involved in converting currencies may reduce or finish off the profits earned.
Brief arbitrage opportunities
Arbitrage opportunities may not last very long and if you do not act fast then there is no gain. Also, you may execute a trade when arbitraging and the price of the assets end up converging in the different markets. This is due to the elimination of arbitrage opportunities in the markets. This may result in losses for you.
Arbitrage can be a profitable opportunity for investors. However, it is important to act fast when the opportunity arises.
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