#ArbitrageTradingStrategy What Is Arbitrage?
Arbitrage takes advantage of market inefficiencies and exploits short-lived variations in the price of identical or similar financial instruments in different markets or vehicles. Arbitrage trades are commonly made in stocks, commodities, and currencies, but can be accomplished with any asset.
Key Takeaways
Arbitrage brings markets closer to efficiency.
Market inefficiency means the price of an asset does not accurately reflect its true value, creating profit opportunities.
Arbitrageurs usually work for financial institutions, frequently trading large financial transactions.
Understanding Arbitrage
Arbitrage can be used with any asset type but occurs most commonly in liquid markets such as commodity futures, well-known stocks, or major forex pairs. These assets can often be transacted in multiple markets at once. This creates rare opportunities for purchasing in one market at a given price and simultaneously selling in another market at a higher price. In principle, the situation creates an opportunity for a risk-free profit for the trader; however, in today's modern market, these circumstances could indicate a hidden cost not immediately apparent to the arbitrageur.
Arbitrage provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods. With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly, and the opportunity is eliminated, often in a matter of seconds.
Examples of Arbitrage
As a straightforward example of arbitrage, consider the following: The stock of Company X is trading at $20 on the New York Stock Exchange (NYSE), while, at the same moment, it is trading for $20.05 on the London Stock Exchange (LSE).
A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a profit of 5 cents per share.
The trader can continue to exploit this arbitrage until the specialists on the NYSE run out of inventory of Company X’s stock, or until the specialists on the NYSE or the LSE adjust their prices to wipe out the opportunity.