Arbitrage is a trading strategy that involves simultaneously buying and selling an identical or similar asset in different markets to profit from a temporary price difference. The core idea is to exploit market inefficiencies where the same asset is priced differently across two or more venues.
How Arbitrage Works:
Arbitrageurs (traders who employ this strategy) look for situations where:
* The same asset is priced differently across two or more markets. For example, a stock might be trading for $100 on one exchange and $100.05 on another.
* Two assets with identical cash flows are not trading at the same price.
* An asset with a known future price is not trading today at its discounted value, based on risk-free interest rates.
When an arbitrage opportunity is identified, the trader will buy the asset in the market where it is cheaper and simultaneously sell it in the market where it is more expensive. The profit is the difference between the selling price and the buying price, minus any transaction costs.
Key Characteristics of Arbitrage:
* Low Risk (in theory): Pure arbitrage is considered "risk-free" because the profit is locked in at the time of execution. However, in reality, there are always some risks involved (see "Risks" below).
* Small Price Differences: Arbitrage opportunities typically involve very small price discrepancies. To make a substantial profit, arbitrageurs often trade large volumes.
* Speed is Crucial: Price differences are usually fleeting. Arbitrageurs, especially in modern markets, rely on sophisticated algorithms and high-frequency trading (HFT) systems to identify and execute trades almost instantaneously.
Types of Arbitrage Strategies:
* Pure Arbitrage (or Spatial Arbitrage / Cross-Exchange Arbitrage): This is the most straightforward form, where the same asset is bought on one exchange and simultaneously sold on another to profit from the price difference. This can happen with stocks listed on multiple exchanges, currencies, or commodities.
* Merger Arbitrage (or Risk Arbitrage): This strategy capitalizes on the price difference between a target company's stock and the acquiring company's offer price during a merger or acquisition. Traders buy shares of the target company, anticipating that their price will rise closer to the acquisition price once the deal is finalized. There's a "risk" here because the merger might not go through.
* Convertible Arbitrage: This involves exploiting price discrepancies between a company's convertible bonds and its underlying common stock. An arbitrageur might take a long position in the convertible bond and simultaneously short the underlying stock.
* Triangular Arbitrage: This strategy is common in foreign exchange markets. It involves exploiting discrepancies in exchange rates among three different currencies. For example, converting USD to EUR, then EUR to GBP, and finally GBP back to USD, aiming to end up with more USD than you started with.
* Statistical Arbitrage: This uses quantitative models and algorithms to identify temporary price deviations between statistically related assets. When the relationship deviates from the norm, traders will take positions expecting the prices to revert to their historical correlation.
* Dividend Arbitrage: This involves buying a stock just before its ex-dividend date (the date that determines who receives the dividend) to capture the dividend payment, and then potentially selling it quickly thereafter.
* Futures Arbitrage: This involves exploiting price differences between a stock's spot (cash) price and its futures contract price.
Risks of Arbitrage Trading:
While often described as "risk-free," arbitrage is not without its challenges:
* Execution Risk: The price difference can disappear before the trades are fully executed, especially in fast-moving markets. This is why speed and automation are critical.
* Liquidity Risk: There might not be enough buyers or sellers in one of the markets to execute the necessary large volume of trades at the desired price, especially for less liquid assets.
* Counterparty Risk: In over-the-counter (OTC) markets, there's a risk that the counterparty to the trade might default.
* Market Risk (for certain types of arbitrage): Strategies like merger arbitrage carry market risk because the underlying event (the merger) might not happen or might be altered, leading to losses.
* Transaction Costs: Brokerage fees, exchange fees, and taxes can eat into the small profit margins of arbitrage opportunities, sometimes making them unprofitable.
* Technological Risk: System failures, connectivity issues, or delays in data feeds can prevent timely execution.
* Competition: As more sophisticated algorithms and traders enter the market, arbitrage opportunities become rarer and shorter-lived.
In conclusion, arbitrage trading strategies aim to exploit temporary pricing inefficiencies across different markets or related assets. While they offer the potential for low-risk profits, successful execution requires speed, advanced technology, and careful management of various risks.