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Arbitrage exploits inefficiencies in the market that otherwise wouldn’t exist under conditions of perfect interest rate parity. Without price inefficiency (i.e., market prices on one exchange not having caught up to the real market price reflected on another), there’s no profit margin and therefore no incentive for the transaction.
Arbitrage describes the process of simultaneously buying and selling a financial instrument across more than one market or exchange. Since true arbitrage plays are made simultaneously, the trader assumes no risk in the transaction—they buy low and sell high at the same time.
However, unless you’re a major institutional investor with high-powered real-time trading software to lean on, true arbitrage plays are hard to come by. But that doesn’t mean you can’t use arbitrage trading to your advantage, whether you trade options, stocks, cryptocurrencies, or commodities and precious metals.
Arbitrage 101
Markets are never entirely efficient. Arbitrage opportunities will always emerge wherever price action discrepancies exist between markets. There exists an asymmetry of information between sellers and buyers, which implies that the seller and buyer won’t agree on how to accurately price an asset.
These situations, known as “negative spreads,” are arbitrage opportunities and they arise whenever there’s a discrepancy between an effective bid and ask. If the buyer and seller had access to the same information regarding the value of the asset—in other words, perfect market efficiency—then the asset would be priced identically between the parties and there would be no arbitrage opportunity.
Price imbalances are short-lived, so to make money arbitrage trading you’ve got to be quick to buy and sell the asset.
Hedge funds and other institutional investors do this well because they leverage expensive and highly sophisticated arbitrage trading software running complex algorithms that detect undervalued assets and purchase them instantaneously as well as a put option. For the average individual investor, finding an arbitrage opportunity is a bit like finding a diamond in the rough.
The Garage Sale Example
Arbitrage, at its core, isn’t a complicated process. If you’ve ever flipped a garage sale item for a profit, then you understand the benefit of arbitrage.
Purchasing an old comic book for a dollar at a garage sale and then selling it later that day to a collector for $100 is an arbitrage play with a $99 profit. Since there are price inefficiencies between the garage sale market and the collector market, it’s the trader’s responsibility to take advantage of these discrepancies and, in doing so, correct them. Without arbitrage plays, the market would remain inefficient.
It’s important to note, though, that the garage sale example used above isn’t a true arbitrage play because there’s a lag time between the purchase and the sale of the comic book. Even if you were able to buy and sell the item within seconds of each other (even within microseconds), the inefficiency between the market prices can narrow and correct itself. Therefore, transactions such as these are never entirely risk-free unless they’re simultaneous.
Types of Arbitrage
There are several trading opportunities that can be categorized as arbitrage. I’ve listed a handful of the most popular forms of arbitrage across all tradeable markets.
- Retail arbitrage: Finding retail products and flipping them for a higher price (e.g., buying a baseball card from a thrift store and selling it at a profit on eBay).
- Convertible arbitrage: Involves purchasing a convertible security and shorting its stock.
- Risk arbitrage: Using fundamental analysis to forecast stock movements before a merger and acquisition (e.g., long position on the target stock, short position on the acquirer).
- Negative arbitrage: Occurs when the interest rate paid on debt exceeds the interest rate at which the instrument is invested.
- Statistical arbitrage: StatArb uses complex statistical modeling to detect differently-priced financial instruments that are mean-reverting from both long and short positions—these algorithms require intense computational power accessible only to big-budget institutional investors and hedge funds.
Forex Arbitrage
Traders often look to foreign exchange (Forex) markets for arbitrage opportunities. For instance, a triangular forex arbitrage strategy would seek out currency pairs, say, USD/CAD and COP/CAD, and find that the US dollar is undervalued relative to the Colombian peso, but overvalued compared to the Canadian dollar.
To exploit the price differences across the currencies, the trader could purchase CAD with USD, and then purchase COP with CAD, which they later convert back to USD for a profit.
Arbitrage Trading: Weighing the Trade-offs
Between trading fees and expensive remote-alert software, the cost-per-transaction when arbitrage trading can easily exceed whatever profits you stand to gain.
When the best-performing hedge funds or investment banks arbitrage trade, they’re making multi-million-dollar transactions and purchasing put options on them instantaneously. Even small fluctuations in asset prices can be exploited by large institutional investors within seconds. Almost instantly, the market corrects, and small-time investors are left without the arbitrage opportunity.
Arbitrage trading isn’t without its share of risks. Just as you can make a respectable profit by flipping an undervalued currency or stock option, you can see your profits dwindle by paying a 1% trading fee, or you might find the market correct itself before you can follow through on the sale.
Ready To Take Your Trading Game Up A Notch?
If finding price imbalances were easy, everyone would be making arbitrage plays. But it isn’t, so they aren’t. Luckily, you can take your day trading or swing trading game up a notch by subscribing to one of the top trading newsletters that will help you find the same undervalued, diamond-in-the-rough assets that the deep-pocket institutions do.
When done correctly, market arbitrage opportunities are one of the few venues for riskless profit. Thanks to the natural inefficiency of markets, there are positive spreads that arise from differently-priced assets—the downside, though, is that trading fees can outweigh whatever profits you might make on the arbitrage play.
Whether you’re considering pursuing arbitrage trading, or you’d rather stick to tried-and-true strategies friendlier to the average retail investor, it’s never too late to get started. Or, if you want to ditch high trading fees, you can leverage bitcoin and cryptocurrency trading options for more lucrative arbitrage opportunities.
Liam Hunt, M.A., is a financial writer covering global markets, monetary policy, retirement savings, and millennial investing. His commentary and analysis have been featured in the New York Post, Reader's Digest, Fox Business, and Forbes.
