Last Updated on 3 November, 2022 by Samuelsson
Arbitrage Trading: What Is It?
In the world of financial trading, there are alternative strategies and tactics traders use to profit from the market, which do not require technical analysis to time the market or the typical “buy and hold” tactics used by most long-term investors. Arbitrage trading is one of those strategies, but what does it actually mean?
Arbitrage trading is the act of buying a security in one market and simultaneously selling it in another market at a higher price so as to profit from the temporary difference in prices in the two markets. Arbitrage opportunities exist as a result of market inefficiencies, which it both exploits and resolves. In the stock market, traders exploit arbitrage opportunities by purchasing a stock on a foreign stock exchange where the equity’s share price has not yet adjusted for the exchange rate.
In discussing this topic, we will try to answer the following questions:
- What is arbitrage trading?
- Understanding arbitrage trading: How do you make money with arbitrage?
- Is arbitrage trading still possible?
- What are the three types of arbitrage?
- Is arbitrage trading easy?
- Is arbitrage trading risk free?
- Can you lose money with arbitrage?
- Is crypto arbitrage profitable?
- Is arbitrage trading illegal in the US?
What is arbitrage trading?
Arbitrage trading is the act of buying a security in one market and simultaneously selling it in another market at a higher price so as to profit from the temporary difference in prices in the two markets. Arbitrage trading opportunities exist as a result of market inefficiencies, and in trying to exploit the inefficiencies, they are resolved.
For arbitrage trading to take place, there must be a situation of at least two equivalent assets with differing prices. That is, the trader tries to profit from the imbalance of asset prices in different markets — the simplest form of arbitrage is purchasing an asset in the market where the price is lower and simultaneously selling the asset in the market where the asset’s price is higher.
The price differences may be typically small and short-lived, but the returns can be impressive when multiplied by a large volume, which is why the strategy is more common among big players like wealthy investors, prop trading firms, and hedge funds.
Arbitrage trades can be made in stocks, commodities, Forex, and even cryptocurrencies. In the stock market, traders exploit arbitrage opportunities by purchasing a stock on a foreign stock exchange where the equity’s share price has not yet adjusted for the exchange rate, which is in a constant state of flux.
Although arbitrage is one alternative investment strategy that can prove exceptionally profitable when leveraged with enough volume, it also carries some risks. To effectively include arbitrage in your alternative investment strategy, it’s critical to understand how it works.
Understanding arbitrage trading: How do you make money with arbitrage?
Arbitrage is probably one of the oldest trading strategies to exist. Traders who engage in the strategy are called arbitrageurs. They make money by monitoring different markets to spot price discrepancies between them. When they spot a reasonable price difference, they buy the security in the market where it is selling at a lower price and simultaneously sell it in the market where it is selling at a higher price.
The concept of arbitrage is closely related to the market efficiency theory, which states that for markets to be perfectly efficient, there must be no arbitrage opportunities. That is, all equivalent assets should converge to the same price, and the convergence of the prices in different markets measures market efficiency. Arbitrage provides a mechanism to ensure that prices do not deviate substantially from fair value for long periods of time because, as traders try to exploit the price differences, prices converge.
With advancements in technology, it has become extremely difficult to profit from pricing errors in the market. Even though 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.
Is arbitrage trading still possible?
Yes, it is still possible to make use of arbitrage strategy in the various markets. Arbitrage can be used whenever any stock, commodity, or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price. The situation creates an opportunity for a risk-free profit for the trader.
All that is needed is to be able to monitor the market and spot a reasonable difference in prices of a security between two exchange markets. The price difference must be big enough to take care of the trading costs and still make profits.
Arbitrage trading platform
There is no specific arbitrage trading platform. However, traders can create arbitrage trading software that would monitor the markets to search for arbitrage opportunities and place the trades. These are just computer algos that you can develop yourself or buy from the vendors.
Arbitrage trading example
Let’s take a look at a common example of an arbitrage trading opportunity where a stock is listed on stock exchanges in two different countries.
Now, let’s assume that a trader finds a stock (let’s call it stock X) that is listed both on the NYSE and Canada’s TSX. Stock X is trading at CAD 12.00 on the TSX and at the same time, it trades at $9.00 on the NYSE.
Let’s further assume the exchange rate of USD/CAD is $1.21, which means that $1USD = $1.21CAD and $9.00 = 10.89 CAD. So, the stock is trading cheaper on the NYSE. Under this set of circumstances, a trader can purchase shares of stock X on the NYSE for 10.89 CAD and simultaneously sell the same stock on the TSX for 12.00 CAD. This would give him a profit of 1.11 CAD per share. If the cost of buying and selling the stock is equivalent to 0.40 CAD, the trader would make a net profit of 0.71 CAD per share. If the trader bought 1000 shares, he would have made 710 CAD within a few minutes.
What are the three types of arbitrage?
There are several types of arbitrage, including pure arbitrage, merger arbitrage, convertible arbitrage, liquidation arbitrage, dividend arbitrage, statistical arbitrage, and pairs trading. However, we will focus on the first three, which are the most common forms.
1. Pure Arbitrage
This is the kind of arbitrage we have been explaining all this while. It refers to a scenario where an investor simultaneously buys and sells a security in different markets to take advantage of a price difference. Thus, the terms “arbitrage” and “pure arbitrage” are often used interchangeably.
Pure arbitrage can be used for securities that are listed on different exchanges — for example, a large multinational company may list its stock on the New York Stock Exchange (NYSE) and Toronto Stock Exchange. Any security that is traded in multiple markets creates the possibility that prices will temporarily fall out of sync, and when this price difference occurs, pure arbitrage trading opportunities emerge.
Another factor that creates pure arbitrage opportunities is foreign exchange rates that lead to pricing discrepancies. In essence, pure arbitrage is a strategy that allows an investor to take advantage of inefficiencies within the market. With trading becoming increasingly digitized, it’s become more difficult to take advantage of pure arbitrage scenarios, as pricing errors can now be rapidly identified and resolved. As such, the potential for pure arbitrage has been reduced.
2. Merger Arbitrage
This is a type of arbitrage that tries to take advantage of a potential merger between two publicly traded companies. It typically involves locating an undervalued company that has been targeted by another company for a takeover bid. This bid would bring the company to its true value. If the merger goes through successfully, those who bought the acquired company will profit; however, if the merger falls through, the share price may drop.
Here is how it works: a merger involves two parties — the acquiring company and its target. The acquiring company must purchase the outstanding share of said company, and in most cases, this is at a premium to what the stock is trading for at the time of the announcement. So, this presents an arbitrage opportunity when a trader buys the target company before the merger.
Since the target company’s price rarely matches the deal price but rather trades at a slight discount, traders can exploit the opportunity by buying the target. However, as more traders buy the target company, its share price goes up, approaching the deal price.
The most common form of merger arbitrage involves an investor purchasing shares of the target company at its discounted price so as to profit once the deal goes through. However, there are other forms of merger arbitrage. For example, a trader who believes a deal may fall apart might choose to short shares of the target company’s stock.
3. Convertible Arbitrage
This is a form of arbitrage related to convertible bonds (convertible notes or convertible debt). Basically, a convertible bond is a form of corporate bond that gives the bondholder the option to convert it into shares of the underlying company at a later date, often at a discounted rate.
Companies issue convertible bonds because doing so allows them to offer lower interest payments, but it provides investors who engage in convertible arbitrage to take advantage of the difference between the bond’s conversion price and the current price of the underlying company’s shares.
Convertible arbitrage is typically achieved by taking simultaneous positions — long and short — in the convertible note and underlying shares of the company — which positions the investor takes and the ratio of buys and sells depends on whether the investor believes the bond to be fairly priced.
If the bond is considered to be cheap, they usually take a short position on the stock and a long position on the bond. But if the investor believes the bond to be overpriced, they might take a long position on the stock and a short position on the bond.
Is arbitrage trading easy?
Yes, arbitrage trading is easy for an experienced arbitrageur who knows what they are doing. What is required is to be able to monitor the markets to identify price differences across different markets that are big enough to cover the trading costs and still make profits. However, the process may seem like a complicated transaction to the untrained eye.
Is arbitrage trading risk free?
Although arbitrage trades are quite straightforward and are thus considered low-risk, it is never risk free. Risk can come in various forms. For example, when buying and selling on various exchanges, the price can fluctuate and remove the potential profit or even end up making the trade a losing one.
Can you lose money with arbitrage?
Yes, you can lose money with arbitrage especially if you don’t have adequate experience before engaging in such a trade. It is not any price discrepancy in an asset that can make you profit.
It takes adequate knowledge and experience to know, even without calculation, whether the difference in price is enough to take care of the cost of buying in one market and selling in another market. If you engage in arbitrage trading when the price difference is not big enough to cover the cost and make you profit, you might end up losing.
Is crypto arbitrage profitable?
Of course, cryptocurrency arbitrage can certainly be profitable; as long as adequate price differences exist (which they certainly do), there will be a way to make money. However, that doesn’t necessarily mean it’s something you can do. To trade crypto arbitrage profitably, you have to identify exchanges with price discrepancies and be fast enough to buy, transfer, and sell in a short time to profit from the price difference.
Is arbitrage trading illegal in the US?
Of course, arbitrage trading is legal in the US. In fact, it is not only legal but also encouraged, as it contributes to market efficiency. In addition to that, arbitrageurs also serve a useful purpose of providing liquidity in different markets.