What is Arbitrage?

Arbitrage is a strategy to exploit price differences in different markets for the same asset. For it to happen, there must be at least two equivalent assets with different prices. Basically, arbitrage is a situation where a trader can take advantage of the imbalance of asset prices in different markets. The simplest form of arbitrage is to buy an asset in the market where the price is lower and simultaneously sell the asset in the market where the price of the asset is higher.

The application makes use of the assumptions of the "effective market" theory , which suggests that a security or an asset with similar returns and similar risks should be valued at the same price in the markets.

However, as it is known, prices may differ between markets due to factors such as different exchange rates, supply restrictions or demand intensity. Therefore, when the price of a security is low in one market and high in another, arbitrageurs trade to make risk-free profits.

Arbitrage is a widely used trading strategy and is probably one of the oldest trading strategies in existence. Traders who implement the strategy are called arbitrageurs .

For example, if a gold bar trades at $10,000 in one market and $10,080 in the other, an arbitrageur can easily make a profit of $80.

There is also arbitrage opportunity in the stock market. However, such opportunities are often rare.

How Does Arbitrage Work?

There should be no arbitrage opportunities in an active market where stocks, bonds, currencies and other assets are priced at their true value. But global markets are sometimes inefficient and there may be price or rate mismatches between markets. In this way, investors can monetize these inefficiencies through a process known as “arbitrage”.

Of course, arbitrage cannot occur unless there are price differences between financial institutions. Today, such price discrepancies only last a few milliseconds. In addition, these differences are usually very small. That's why it doesn't usually make sense to engage in arbitrage strategies unless you have a large amount to invest.

Advantages of Arbitrage

Arbitrage can allow you to make money. That's why we've listed the key advantages of arbitrage for you below :

1. Risk-free profits

Profits from correctly executed arbitrage can be considered risk-free, as the buy and sell price is known in advance. Unlike trading stocks or bonds through the traditional strategy of buying a security now and selling it at some point in the future, arbitrage does not require betting on a security's future performance.

2. Zero capital investment

If you are only taking advantage of pricing errors or inconsistencies (for example, through local arbitrage), you don't even need to invest your own capital to take advantage of an arbitrage opportunity.

Risks for Arbitrage

As an investor, you may face the following risks when arbitrage:

1. Difficulty Following

Mergers and acquisitions developments are difficult to follow as they occur instantly and without prior notice. Also, there is no promise that the news is reliable if followed. While it may be wrong, investors who take long and short positions under risk arbitrage can lose their investments and incur huge losses.

2. Transaction Risk

Transaction risk is the risk taken by the investor if the purchase is not realized. If it fails, it could have negative effects on the prices of both companies and force the investor to lose large sums of money.

3. Price Drop

It may drop to very low levels as investors only anticipate that the acquiring company's share price may rise. In such a case, investors can lose money on their long positions.

4. Uncertain Timetable

Engaging in risk arbitrage after acquisition or merger news is risky because you never know how long a deal will take. It can take months for investors to tap into stock derivatives and allow the stock price to fluctuate.

What are the Trade Conditions Necessary to Arbitrage?

Arbitrage can occur when the following conditions are met:

1. Asset price imbalance:

This is the primary condition for arbitrage. Price imbalance can take several forms:

The same asset is traded at different price in the different market. 

The Assets with similar cash flow are traded at the different prices. 

An asset with a known future price that is already bought and sold at a price different from the expected value of future cash flows.

2. Simultaneous trading:

Buying and selling the same or equivalent assets should be done simultaneously to capture price differences. If the transactions are not executed simultaneously, the transaction may be exposed to significant risks.

Trading with Arbitrage

Although this is a simple strategy, very few mutual funds rely solely on such a strategy. Because not everyone can implement the difficulties that come with taking advantage of the short-lived situation. With the rise of electronic commerce, which can execute buy and sell orders in less than a second, mispriced asset spreads emerge for a very short time. Increasing transaction speed has increased the efficiency of the markets in this sense.

Additionally, equal assets with different prices often show a small difference in price, which is smaller than the transaction costs of an arbitrage trade. This effectively eliminates the arbitrage opportunity.

Arbitrage is often used by large financial institutions as it requires significant resources to identify opportunities and execute transactions. Derivative contracts and complex financial instruments are often used to find equivalent assets. Derivatives trading often involves margin trading and the large amount of cash required to execute trades.

Pictures are alternative assets with subjective value and tend to lead to arbitrage opportunities. For example, an artist's paintings may sell cheaply in one country, but sell significantly more in another culture where the painting style is more appreciated. An art dealer can arbitrage by buying paintings where they are cheaper and selling them in the country where they are fetching a higher price.