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Arbitrage How does it work?
A trader using an arbitrage strategy looks for assets that are traded at different prices in different markets. For example, if the price of a stock is lower in one market and higher in another, the trader buys the stock in the cheaper market and immediately sells it in the more expensive market, making a profit from the price difference.
Examples of arbitrage:
• Currency arbitrage: Take advantage of price differences between different currency pairs in different markets.
• Triangular arbitrage: Take advantage of price differences between three or more currencies by trading a series of currency pairs to achieve a profit.
• Cryptocurrency arbitrage: Take advantage of price differences of cryptocurrencies across different exchanges.
Advantages of arbitrage:
- Low risk: In theory, arbitrage is a low-risk strategy, as the trader executes trades to exploit price differences, reducing exposure to market volatility.
- Potential profits: If executed correctly, arbitrage can lead to consistent profits, especially in volatile markets or with newly listed assets.
Risks of arbitrage:
- Difficulty in identifying opportunities: Arbitrage opportunities can be rare and short-lived, requiring careful analysis and quick responses.
- Transaction costs: Transaction costs, such as fees and spreads, can reduce or eliminate potential profits.
- Execution risk: Timely execution of trades is crucial for arbitrage, and any delays can result in losses.
- Counterparty risk: In some cases, arbitrage can involve counterparty risk, meaning the risk that one of the parties involved in the transaction fails to fulfill their obligations.