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Investing Basics: Understanding Arbitrage


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Arbitrage means taking advantage of price differences across markets to make a buck. If a currency, commodity or security—or even a rare pair of sneakers—is priced differently in two separate markets, traders buy the cheaper version and then sell it at the higher price to make money.

Understanding How Arbitrage Works

Arbitrage is an investing strategy in which people aim to profit from varying prices for the same asset in different markets. Quick-thinking traders have always taken advantage of arbitrage opportunities in markets. Today, financial professionals use sophisticated algorithms to discover and exploit complicated arbitrage strategies.

Often the price discrepancies that are at the heart of arbitrage involve multiple geographies, like you see in the foreign exchange (forex) market. They also occur when there is a lag in information, as can be the case with stocks trading on different exchanges or in crypto arbitrage.

Big institutions, hedge funds and professional traders may also be able to leverage what’s known as statistical arbitrage, which uses algorithms to identify temporary price mismatches in two or more related securities.

Arbitrage usually involves making multiple transactions and using very large amounts of money to get a meaningful return, making it an expensive approach to investing. While markets rarely operate as efficiently as they might in the ideal world of theory, price differences typically are small, and arbitrage opportunities disappear almost as rapidly as they are discovered.

Different Types of Arbitrage

Retail Arbitrage

Retail arbitrage is an example of arbitrage that everyone can instantly understand. When there’s a particularly popular item—say a hot new toy, a rare pair of sneakers or a new mobile phone—people buy it in one market (a physical store, perhaps) and then sell it in another market (online, maybe) to turn a quick profit.

This is a classic strategy that perfectly illustrates the basics of arbitrage. The buyer assumes the risks of acquiring inventory and the uncertainty of whether they’ll be able to sell it at the price they’d hoped for. But the arbitrage payoff could be huge!

Simple Arbitrage

Simple arbitrage involves simultaneously buying and selling one asset on two different exchanges. Unlike retail arbitrage, traders may assume very little risk because the transactions are executed at the same time.

Consider, for example, a public company that trades on multiple stock exchanges. If the stock is trading at different prices on the different exchanges, a simple arbitrage strategy entails buying the stock at the lower price on one exchange while at the same time selling it at the higher price on the other exchange.

Merger Arbitrage

A riskier arbitrage strategy involves leveraging mergers and acquisitions of public companies. Merger arbitrage is a longer-term proposition: Traders buy the shares of a public company that’s targeted for a takeover with the aim of selling the stock once the deal is completed.

Unlike other forms of arbitrage, the price discrepancy isn’t apparent upfront in merger arbitrage. There’s no guarantee of earning a risk-free profit—rather, traders are betting that one could materialize.

Doing merger arbitrage means you have to lock up your money for a longer period of time plus take on the risk that the merger doesn’t materialize, or you aren’t able to resell your shares at the value you’d aimed for.

Arbitrage in Forex Markets

The foreign exchange market is the largest financial market in the world—and it’s ripe for arbitrage strategies. Because all forex trading occurs over the counter (OTC) through a global network of banks and other financial institutions, the decentralized nature of this market sometimes leads to pricing disparities.

What’s more, exchange rates constantly fluctuate based on supply and demand, so temporary price mismatches are common. There’s also a lot of liquidity in the currency market, meaning it’s easy to execute trades for an arbitrage strategy. All of these reasons enable arbitrage to be widely used in forex trading.

To take advantage of these opportunities, though, you’ll likely need highly specialized tools, access to accurate, real-time currency pricing data and a margin account to amplify your returns.

In addition, special forex calculators help traders identify and quantify the profit as well as gauge the risk of various arbitrage strategies in forex markets. Arbitrageurs can test drive free online calculators; more sophisticated calculators are sold by forex brokers and other providers.

Triangular Arbitrage

Triangular arbitrage is a strategy that’s unique to forex markets. As the name suggests, triangular arbitrage involves three currency pairs, adding a layer of complexity that requires sophisticated trading capabilities.

While very uncommon, a triangular arbitrage opportunity could present itself when there are discrepancies in the foreign exchange market. Here’s how it works: A forex trader would use Currency A to buy Currency B, then Currency B to buy Currency C, and finally Currency C to buy Currency A, hopefully accruing a tidy profit in the process.

With this unique strategy, the differences between exchange rates are very minimal, requiring you to convert very large amounts of money to eke out even small profits.

The Bottom Line

Be it in the forex markets or elsewhere, the appeal of arbitrage strategies is obvious: Identify mismatches in prices, and you just might just be able to lock in a risk-free return. That said, arbitrage typically requires large amounts of capital and deep knowledge of markets to be executed correctly.



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