Arbitrage: Definition, Types, How Does It Work with Example

What is Arbitrage?

Arbitrage comes from the French word arbitrer, which means “to judge” or “to referee.” In finance, it refers to judging the price differences between markets and making money from them. When someone spots a price gap between two markets, they can buy the asset at a lower price and sell it at a higher price almost instantly. The goal is to take advantage of these differences before they disappear.

Key Takeaways:

• Arbitrage is about buying and selling the same asset in different markets for a profit.
• It requires quick decision-making and knowledge of market prices.
• Arbitrage can happen in stocks, cryptocurrencies, forex, and even real estate.
• Profits from arbitrage might seem small at first, but they can add up over time.
• There are risks, but with the right strategy, losses can be avoided.

Types of Arbitrage

Pure Arbitrage

Pure arbitrage involves buying and selling the same asset in two or more different markets. Imagine you see a stock selling for $100 in New York but $101 in London. If you buy the stock in New York and sell it in London, you make a $1 profit, minus fees. This is considered pure arbitrage because the asset is exactly the same, but the prices vary.

Risk Arbitrage

Risk arbitrage occurs when investors make bets on events, like mergers or acquisitions, that could change an asset’s price. If a company announces a takeover, the stock price of the target company may rise. Traders then buy shares in the target company, hoping to profit when the acquisition is complete. The risk is that if the deal doesn’t go through, the price might fall.

Statistical Arbitrage

This is a bit more complex. Traders use mathematical models to predict future price movements. By studying past data and using algorithms, they try to find patterns that signal an opportunity for profit. Statistical arbitrage often involves buying and selling baskets of securities.

Why Does Arbitrage Happen?

Arbitrage opportunities exist because markets aren’t always efficient. Prices of assets might differ in different markets because of time zone differences, transaction costs, or delays in information. While markets are constantly trying to correct themselves, the gaps in pricing provide arbitrage opportunities. Technology plays a big role in this; traders use advanced software to spot price differences and execute trades in seconds.

How Does Arbitrage Work?

Let’s break down a simple example of arbitrage using a stock. Imagine you notice a company’s stock priced at $50 on the New York Stock Exchange (NYSE) but $52 on the London Stock Exchange (LSE).

1. You buy 100 shares of the stock on NYSE at $50, costing you $5,000.
2. You sell those 100 shares on LSE at $52, receiving $5,200.
3. You’ve made a $200 profit before transaction costs.

Arbitrage Example by Age and Risk

Now, let’s consider a more personalized example of how arbitrage can look for people with different risk tolerances and at various ages. Younger investors might be more willing to take risks since they have time to recover from potential losses. On the other hand, older investors might prefer safer, more conservative arbitrage strategies.

Low-Risk Arbitrage (Age 60+)

For a 60-year-old nearing retirement, a low-risk strategy might focus on bond arbitrage. Bonds in different markets can sometimes be mispriced due to currency differences. A person at this age would focus on safe, government-backed bonds. Let’s say U.S. government bonds are yielding 3% in one market, while in another market, due to exchange rate differences, the effective yield is 3.5%. The investor could profit from this small, low-risk difference.

Calculation:

• Buy 10 bonds at $1,000 each in Market A (3% yield).
• Sell 10 bonds in Market B (3.5% yield).

In this case, the profit margin is small, but because bonds are stable, the risk is minimal.

High-Risk Arbitrage (Age 25-40)

A younger, more risk-tolerant individual might focus on cryptocurrency arbitrage. Cryptocurrencies like Bitcoin or Ethereum can have price differences of several hundred dollars across exchanges. By quickly moving between these exchanges, the trader can buy low and sell high.

Calculation:

• Buy 1 Bitcoin at $30,000 on Exchange A.
• Sell 1 Bitcoin at $30,500 on Exchange B.
• Profit: $500 before transaction fees.

This method is riskier because cryptocurrency prices are more volatile and can change quickly. It also requires fast internet and constant monitoring of the markets.

The Arbitrage Formula

To calculate arbitrage profits, the following basic formula can be used:

Profit = (Selling Price – Buying Price) – Transaction Costs

Let’s apply this formula to the earlier example of stock arbitrage between NYSE and LSE:

Example:

• Buying Price on NYSE = $50
• Selling Price on LSE = $52
• Transaction Costs = $1 per share (buy and sell combined)

Profit = ($52 – $50) – $1 = $1 per share.

For 100 shares: $1 x 100 = $100 total profit.

Even though the profit per share seems small, large volumes and frequent trades can lead to significant gains over time.

Arbitrage Strategies Across Various Asset

Currency Arbitrage in Forex

In forex trading, currency arbitrage involves buying a currency in one market and selling it in another where the price is slightly higher. Since currency exchange rates fluctuate rapidly, this form of arbitrage requires quick decision-making.

Cryptocurrency Arbitrage Trading Strategies

With the rise of digital currencies, many traders are focusing on cryptocurrency arbitrage. By monitoring different exchanges, traders can find price gaps between Bitcoin, Ethereum, and other coins. Arbitrage bots are often used to execute trades automatically when these price differences are detected.

Arbitrage in Real Estate Investing

Real estate arbitrage happens when investors buy properties in undervalued markets and sell them in markets where property values are higher. This can be done by finding homes that are priced lower than market value due to foreclosure or other factors, renovating them, and selling at a profit.

Risks of Arbitrage

While arbitrage is often considered risk-free in theory, real-world trading involves certain risks. These risks can include:

• Execution Risk: The prices may change by the time the trades are executed.
• Transaction Costs: High fees can eat into profits.
• Liquidity Risk: In some markets, there may not be enough buyers or sellers to complete the trade at the desired price.

These factors are why many investors use technology to automate arbitrage trades. Trading platforms and software can execute trades instantly, reducing the chances of price shifts during execution.