At its most basic, arbitrage can be defined as the concurrent purchase and sale of similar assets in different markets in order to take advantage of price differentials.
When a trader uses arbitrage, they are essentially buying a cheaper asset and selling it at a higher price in a different market, thereby taking a profit without any net cash flow.
Theoretically, arbitrage requires no capital and involves no risk but, in reality, attempts at arbitrage will involve both risk and capital.
How Arbitrage Opportunities Occur
The Efficient market hypothesis in the economic theory suggests that financial markets, including all investors and other active participants, will process all the information available to them with regard to asset values, quickly and efficiently. This would allow for very little room for price action discrepancies to occur across various markets.
In practice, however, markets are never 100% efficient all the time due to the prevalence of asymmetrical information between the buyers and sellers within the market.
An example of this inefficiency is when a seller’s asking price for an asset is lower than a buyer’s bid price. This situation is known as a “negative spread”, and is one of the main reasons for the appearance of arbitrage opportunities.
What Is Currency Arbitrage?
Currency arbitrage occurs when financial traders use price discrepancies in the money markets to take a profit. For instance, interest rate arbitrage is a popular way to trade on arbitrage in the currency market, by selling currency from a country with low-interest rates and, at the same time, buying the currency of a country that pays high-interest rates.
The net difference in the two interest rates is the trading profit. This method is also known as “ carry trade”
Another form of currency arbitrage that investors use is known as “cash and carry.” This involves taking positions on the same asset within both the spot market and futures market simultaneously.
In this strategy, an investor will buy a currency and will then short sell the same currency in the futures market. Here, the trader is taking advantage of different spreads offered by different brokers for a specific currency pair.
The different spreads will create a difference in the bid and ask prices, enabling a trader to take advantage of the different rates.
For example, if broker A is offering the USD/EUR pair at 4/3 dollars per euro and broker B is offering this pair at a rate of 5/4 dollars per euro, a trader can convert one euro into USD with broker A, and they will then convert the USD back to EUR with broker B, resulting in a profit.
Statistical arbitrage is derived from a collection of quantitative algorithmic investment strategies. This strategy is aimed at exploiting relative price movements of thousands of financial instruments in different markets through technical analysis.
The ultimate aim of statistical arbitrage is to generate higher than normal trading profits for larger investors. It is worth noting that statistical arbitrage does not lend itself to high-frequency trading. Instead, it is used for medium-frequency trading, with trading periods taking anywhere from a few hours to several days.
In statistical arbitrage, a trader will open a long and short position simultaneously in order to take advantage of inefficient pricing in assets that are correlated.
For example, if a trader thinks that Amazon is overvalued, and Facebook is undervalued, they will open a long position on Amazon and at the same time, a short position on Facebook. This is often referred to as pairs trading.
Another variation on the trade of negative spread is triangular arbitrage. This strategy involves the trading of three or more currencies simultaneously, increasing the odds that market inefficiency will result in profit-taking opportunities.
With triangular arbitrage, a trader tries to find situations where a currency is overvalued in relation to one currency and undervalued relative to another.
For instance, a trader may analyse the USD/JPY, EUR/JPY and EUR/USD currency pairs. If the euro is overvalued relative to the US dollar but undervalued when compared to the yen, the trader could use US dollar to buy JPY, use the JPY to buy EUR and later convert the euros to USD at a profit.
Arbitrage main FAQs
Are there any reasons why an arbitrage won’t work?
In many cases if you see a price discrepancy in your quotes by the time you try to arbitrage it it simply vanishes as if it never existed. There are a few reasons for this. One is when the quoted price you’re seeing is wrong or is simply untradeable. Another possible reason is a bid-offer spread that wasn’t accounted for. And in some cases, it is simply because the model you are using is wrong, or there is some risk factor you haven’t taken account of.
Is arbitrage good or bad?
As with most things in the universe of trading arbitrage is neither good, nor bad. It is simply a way to take profits from the markets. In some cases, you might even call it good since it maintains the efficient market by removing outliers. Others claim arbitrage is bad because it takes advantage of situations that shouldn’t exist, or that may exist by mistake. At the end of the day traders are out there to make profits, and if they can do so by working with any imbalances that occur then that is simply part of the market process.
What are the different types of arbitrage?
Arbitrage involves taking advantage of discrepancies in market prices, but it also takes many different forms. There is risk arbitrage, which involves buying the stocks of companies involved in a merger or acquisition. There is retail arbitrage, which is the buying and selling of physical products like you might see on eBay or Amazon. There is convertible arbitrage which is buying a convertible security and then shorting the underlying stock. And there is statistical arbitrage which works through the use of complex mathematical formulas that trade the markets programmatically to take advantage of even small price discrepancies.
Arbitrage allows a trader to exploit price discrepancies in assets, but this requires speed and adequate algorithms. In the financial markets, prices usually correct themselves in a short time. As a result, you will need to act quickly in order to take advantage of these trading opportunities.