Arbitrage trading is a strategy that seeks to profit from price differences of the same asset across different markets or exchanges. The core principle is to simultaneously buy and sell identical or equivalent securities in different markets to capture risk-free profits from temporary price discrepancies.
## How Arbitrage Works
The strategy exploits market inefficiencies where the same asset trades at different prices in different locations. Traders buy the asset where it's cheaper and sell it where it's more expensive, pocketing the difference as profit. In efficient markets, these opportunities are typically small and short-lived.
## Types of Arbitrage
**Spatial Arbitrage** involves trading the same asset on different exchanges or geographic markets. For example, if Bitcoin trades at $50,000 on one exchange and $50,100 on another, an arbitrageur could buy on the first exchange and sell on the second.
**Temporal Arbitrage** takes advantage of price differences over time, often using derivatives or futures contracts that are mispriced relative to the underlying asset.
**Statistical Arbitrage** uses mathematical models to identify price relationships between related securities that have temporarily diverged from their historical patterns.
**Merger Arbitrage** involves buying shares of a company being acquired and sometimes shorting shares of the acquiring company to profit from the spread between the current price and the deal price.
## Requirements and Challenges
Successful arbitrage requires fast execution, low transaction costs, and sufficient capital to make the small profit margins worthwhile. Modern markets are highly efficient, so most arbitrage opportunities are captured by high-frequency trading algorithms within milliseconds.
The main risks include execution risk (prices moving before both sides of the trade are completed), counterparty risk, and regulatory changes. While arbitrage is theoretically risk-free, real-world factors can introduce unexpected losses.
Arbitrage plays an important role in market efficiency by helping eliminate price discrepancies and ensuring fair pricing across different markets.