Using arbitrage is a relatively risk-free investing strategy that can be appealing; however, it takes a sizable investment to generate significant profits. If you want to understand what arbitrage is, this guide will explain how arbitrage trading works, define different arbitrage types and opportunities, and explain the risks related to it.
What is arbitrage?
A simple definition of arbitrage is when the same asset is selling in two different markets at a different price, enabling traders to buy it at a lower price and instantaneously sell it in another for a higher price to earn a risk-free profit. It means identifying an arbitrage opportunity where the same asset trades in one market for a lower price than another.
Arbitrage, in principle, is a riskless way of making a profit as transactions happen simultaneously and because there is no holding period. However, it isn’t as simple as it sounds – high transaction fees, price fluctuations, and the fact that traders must complete these transactions fast can eliminate already marginal profits.
Technically, two simple explanations depend on the arbitrage opportunity:
- Buy a product for a lower price in market A, sell it for a higher price in market B, and earn a profit;
- Buy product A for a lower price, hold the asset, re-sell for a higher price later on, and make a profit.
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Why do people use arbitrage trading?
Arbitrage trading happens when an identical asset is bought and sold in two contrasting markets to earn a profit from minor discrepancies in listed prices. These value inconsistencies are usually short-lived and corrected quickly – arbitrage strategy exploits these fluctuations.
Arbitrage results from market inefficiencies; arbitrage trading exploits and resolves these inefficiencies simultaneously. An inefficient market is when financial assets don’t reflect their true and fair market value or adhere to the efficient market hypothesis, which states that all financial assets traded across markets always reflect their actual value to traders.
That’s why sometimes the same asset trades at different prices in different markets, and investors who want to profit from these deviations can exploit this opportunity.
It is a relatively risk-free investment strategy, but as price discrepancies are usually marginal, a higher lump sum of the original investment is necessary to create substantial profits, which is why arbitrage investors or ‘arbitrageurs’ are typically institutional investors.
A simple arbitrage trading example
Example: Let’s assume a stock is selling on the New York Stock Exchange (NYSE) for $35, and at the same time, this stock is trading for $30,05 on the London Stock Exchange (LSE). If an investor buys the stock on the NYSE and then immediately sells it on the LSE, he would earn a profit of 5 cents per share.
Investors can exploit this market inefficiency until the stock sells out or when the price is adjusted, and stock market specialists correct price discrepancies.
As you can see, the price dissimilarities are usually marginal, and traders have to invest more money to make a considerable profit. Moreover, as information spreads faster, arbitrage opportunities are decreasing. They are already exhausted, making them much harder to come by as the market is becoming more competent in leveling out differences.
Arbitraging is legal and encouraged in most countries, as it helps reduce market inefficiencies. Arbitrage trading helps the market by facilitating market corrections, eliminating market inefficiencies, and ensuring that prices are more or less the same across different markets.
Who uses arbitrage trading?
Due to low profits and large amounts of money necessary to generate significant gains, individual investors use the arbitrage trading strategy less often, and it is more commonly used by institutional investors who trade on behalf of large financial institutions. Another reason for this is that arbitrage strategy requires simultaneous and split-second buy-sell decisions, which can only be acted on by using arbitrage trading software or obtaining thorough background knowledge.
However, individual investors could also take advantage of arbitrage by investing in an arbitrage fund, a particular type of mutual fund. They can be a good choice for investors wanting to profit without taking on a lot of risks, but due to the nature of arbitrage trading, the actual returns can be unpredictable.
Types of arbitrage trading strategies
Depending on the opportunity, market, and asset, there are simple and more complicated variations of arbitrage types. Below we’ll bring out only some typical techniques, briefly explain each of them, and bring some specific examples.
Some arbitrage practices include:
Pure arbitrage and arbitrage are terms that are used interchangeably – in this case, pure arbitrage means an instant buy-and-sell decision, where an investor simultaneously buys and sells the same asset in two different markets to profit from the price difference.
Risk arbitrage, also known as merger arbitrage, is a strategy where traders try to profit from price differences in the trading price of a company’s stock before an acquisition.
When the acquiring company has announced takeover plans of another company (the target company), the acquiring company’s stock price usually falls, whereas the target company’s stocks generally increase.
As a result, investors create a hedge by taking a long position on the stocks of the target company and short-sell stocks of the acquiring company to profit from this opportunity. It isn’t entirely as risk-free as pure arbitrage, as there is a risk the takeover deal might not go through.
Retail arbitrage is when products, for instance, consumer and retail products and goods, are bought at a lower price in the local market and sold for a higher price with a markup in another.
It is a common practice in e-commerce; for example, Amazon (NASDAQ: AMZN) arbitrage is where local retailers in one market sell their products on Amazon’s website to the US market for a much higher price.
Rental arbitrage is when you rent an apartment or property you don’t own but rent from a long-term rental market to sublet it for a higher price, for example, on short-term rental platforms like Airbnb or HomeAway.
It means that you can generate profits without ever owning the properties – that is, providing the fees you charge from your customers via short-term sublets can cover the long-term rental and other costs of the properties you are renting.
Convertible bond arbitrage
Convertible arbitrage is a more complicated arbitrage strategy; it considers the price differences between a convertible bond and the underlying stock price. A convertible bond is like a standard bond but can be converted into a predetermined number of common stock or equity shares.
A convertible bond arbitrage strategy takes advantage of possible differences in the price by aiming to profit from the mispricing between a convertible bond and its underlying stock by buying the convertible bonds while short-selling the underlying stock.
Statistical arbitrage is another technique that requires more research, knowledge, and understanding; it is where complex statistical models define trading opportunities among several different financial instruments with different prices and need significant computational power.
Futures arbitrage is a cash-and-carry arbitrage opportunity when the underlying asset’s price and the futures contract price deviate. A futures contract is a derivative agreement to buy or sell a specific asset at a particular price at a set date in the future. The seller of the contract agrees to deliver and sell the asset, and the buyer agrees to buy it at a price fixed in the contract.
Cash-and-carry arbitrage exploits pricing inefficiencies between spot and futures markets. Spot market is where commodities sell for immediate delivery and futures for future delivery. It aims to use the little price deviations during this period, with the idea to “carry” the underlying asset until the expiry date and sell it for a profit.
Unlike pure arbitrage opportunities, where trade happens instantaneously, the cash-and-carry strategy isn’t entirely without risk, as it involves holding the asset until the contract expires.
With futures contracts, the actual price of the underlying asset may be different from the price in the contract for some time, and traders can spot these opportunities of mispricing and use it to their advantage; however, for the trade to be profitable, futures contract should be much more expensive relative to the underlying asset.
Covered interest arbitrage
Foreign exchange (FOREX) traders use two-currency arbitrage to profit when they notice differences between two different currency exchange quotes between markets and exploit spreads between the two currencies.
Covered interest rate arbitrage is the practice of using favorable interest rate differentials to invest in a higher-yielding currency to earn a profit and hedging the exchange risk, usually through a forward contract. Covered interest rate arbitrage is a strategy where investors try to profit from the two countries’ currencies’ interest rates.
Currency arbitrage example:
Assume the interest rate in the U.S. might be 5% per year, whereas the interest rate in the Eurozone is 10% per year. Paul has $100,000 to invest, and if he invested this at home in the U.S., he would earn 5%, bringing his total to $105,000.
If he used covered interest rate arbitrage, first, Paul would convert his $100,000 to euros and get 71,429 EUR. Then he would get the new interest rate of 10% in Europe, which would total 78,572 EUR. Finally, once the forward contract expires, Paul can exchange his euros back to dollars at a forward rate of 1 EUR to $1,34, which would come to roughly $105,286.
Earning interest in this way is nowadays rarer, especially when both markets are aware of each other’s exchange rates and as markets try to bring any imbalances to an equal level.
Currency traders can also go with the three-currency arbitrage strategy, or triangular arbitrage, which is slightly more complicated. So it is when traders exploit the currency exchange rate discrepancies and convert from one currency to another to a third to make a profit.
As exchange rates can change fast, large traders use computers and trading software to ensure the price gap is closed on time, losing the opportunity and profits.
Triangular arbitrage example:
For example, Steve has $1,000, and he notices the following exchange rates: EUR/USD = 1.1586, EUR/GBP = 1.4410, and USD/GBP = 1.6851.
He defines an arbitrage opportunity:
- He sells his dollars to buy euros: $1,000 ÷ 1.1576 = €863.85;
- Then converts euros to pounds: €871.38 ÷ 1.4200 = £599.48;
- And sells pounds for dollars: £591.17 x 1.710 = $1010,1901;
- At the end, subtracting the initial investment: $1010,1901 – $1,000 = $10.19;
- Making an arbitrage profit of $10.19, excluding any extra transaction costs or taxes.
As you can see from this example, these deals have to happen very quickly, and arbitrage only performs when substantial sums are invested, as gains are often marginal, and high transaction costs could eliminate any profits.
Common arbitrage trading opportunities
Usually, the most common arbitrage opportunities are from buying and selling assets like stocks, bonds, or other financial instruments, commodities through futures contracts or retail arbitrage, or currencies. Still, a reasonable chance to make a riskless profit can occur anywhere.
More commonly, the following assets have price discrepancies to generate profits:
Security or an asset
It shouldn’t, but it sometimes happens that stocks sell at slightly different prices on two different stock exchanges. Purchasing assets or securities like stocks, bonds, or other financial instruments in one stock exchange or market for a lower price and immediately selling them on another for a higher price.
It includes buying commodity assets like agricultural products or metals via a futures contract, buying it when the price is low, holding the asset, and selling it when it is high.
Currency arbitrage opportunities occur when exchange rates of currencies, for example, Euros, US Dollars, British Pounds, or Canadian Dollars, come at favorable exchange rates and an arbitrage opportunity is present. Also, when there is an exchange rate discrepancy between two different markets, one currency can be sold for another and exchanged back to its original currency, intending to make a quick profit.
Crypto arbitrage is a crypto trading technique that usually follows triangular arbitrage. For example, crypto exchange A is selling a particular cryptocurrency, let’s assume Bitcoin, for a lower price than an exchange B, traders can purchase it on one exchange for a lower cost to sell it on another for more.
However, as straightforward it may sound, there are a few essential things to consider, such as high platform fees, the trading volume, and price slippage – when you get a different price quote than expected at exit or entry to the trade.
Risks of arbitrage trading
In most arbitrage cases, investors can make mostly risk-free profits, especially when realized in real-time, for example, if a stock or a currency is bought and sold simultaneously.
Nevertheless, when it comes to cash-and-carry arbitrage, risks are slightly higher, as traders have to wait and hold the asset for some time before selling it for profit.
Another aspect to consider is that even if the risks are low, so are the profits, and it takes a significant investment to make considerable gains. Although considered a riskless trade, arbitrage trading requires accurate timing and thorough research for it to be successful and profitable, and is susceptible to several drawbacks:
The market is volatile and prices fluctuate, which means buying and selling an asset in two different markets can reduce the spread. Therefore, arbitrage opportunities have to be exploited immediately, otherwise, there is a risk that prices change and trade would incur losses.
Stock and currency exchanges, markets, and platforms have different transaction fees and tax rates, and it takes time to research which fees apply. To make sure fees don’t exceed profits, investors need to determine whether the trade is still profitable after all the taxes and brokerage charges have been deducted.
Requires a significant investment
As arbitrage opportunities occur when there is a slight price difference, the profits are minimal. A lump sum of a more considerable investment is required for the trade to be profitable, which heightens the risk of losing more money if the transaction falls through.
Counterparty default risk
Some arbitrage opportunities are over-the-counter deals; for example, investors are exposed to counterparty default risk for currency arbitrage, and arbitrageurs could encounter losses.
Regulators are getting increasingly better at leveling out price differences across markets, as it is easier nowadays to know what is happening, and eliminating loopholes leaves fewer arbitrage opportunities.
Large corporations can exploit arbitrage opportunities with more significant funds to initiate the trade and benefit from small margins to profit. However, arbitrage trading has three key advantages: relatively low-risk gains, keeping prices of stocks and other various assets across different markets more or less the same, and contributing to an efficient market.
FAQs about arbitrage trading
What is arbitrage trading?
Arbitrage is when the same asset is sold in two different markets at a slightly different price, which poses an opportunity for traders to make a risk-free profit. Arbitrage trading is when an investor buys an asset for a lower price and sells it in another for a higher price. These assets can be stocks, bonds, or other financial instruments, currencies like EUR, US Dollar, GBP, or commodities.
What are the different types of arbitrage?
Depending on the arbitrage opportunity and the asset class, arbitrage trading strategies vary from simple to complicated techniques. For example, some arbitrage strategies include but aren’t limited to pure arbitrage, currency arbitrage, cash-and-carry arbitrage, rental arbitrage, statistical arbitrage, or convertible bond arbitrage.
Is arbitrage trading profitable?
In principle, arbitrage is a risk-free way of making profits because assets are bought and sold simultaneously, and there is no holding period. However, as price differences are usually marginal, high transaction fees and taxes can eliminate already nominal profits, and a higher lump sum of investment is necessary to generate significant gains.
What are the risks of arbitrage trading?
Risks in arbitrage trading are relatively low, but that doesn’t mean it is an entirely risk-free strategy, as it still takes considerable time to research each opportunity. Moreover, as it takes accurate timing for the trade to be successful, arbitrage opportunities are susceptible to market uncertainties and price volatility. Furthermore, it requires a significant investment for the deals to be profitable and can be subject to counterparty default risk.