Arbitrage is the process of opening opposite trading positions simultaneously to make profits from price inefficiencies in the market
What is arbitrage trading?
Arbitrage trading is considered to be risk-free because it uses the exploitation of inherent price imbalances. In simple terms, it is based on the concept of buy low sell high, but with arbitrage the investor knows the buy and sell prices upfront, and any exposure is closed immediately.
Arbitrage means opening opposite positions at the same time in different markets. A trader can buy the asset at a lower price from one market and sell it for a higher price in another market. The two positions cancel each other out, and the trader gets the profit. The profit is made because of market inefficiencies and price imbalances between markets.
Any arbitrage opportunity should be executed quickly, since the price differences between markets (or similar instruments) can be smoothed out in a very short time. In the past there were numerous arbitrage opportunities; nowadays, technological developments are limiting the occurrence of price differences.
Arbitrage trading strategies explained
This trading strategy can be based on a single asset or multiple assets. Hence, there are different strategies and techniques applied in arbitrage trading.
This strategy consists of one single asset. The investor identifies a price difference between brokers or markets. Two positions are opened simultaneously, one buy position and one sell position. There is no holding period since the investor is immediately buying and selling the underlying asset, cashing-in on the difference.
For instance, stock A is trading at a price of $25 at the domestic stock exchange. The same stock can be found on a foreign exchange trading at a price of $26. The investor buys the stock on the domestic exchange and sells the stock on foreign exchange for a higher price. The $1 difference is the profit made from the arbitrage.
Triangular arbitrage is an arbitrage strategy performed with three assets. It is exploiting the price difference between similar assets.
For example, there could be three currency pairs, USD/EUR = 0.9, EUR/GBP = 0.8 and GBP/USD = 1.4. An investor decides to make a profit from this arbitrage opportunity by investing $500,000. The steps involved in the arbitrage are as follows:
Convert dollars to euros ($500,000 x 0.9) = €450,000
Convert euros to British pounds (€450,000 x 0.8) = £360,000
Convert pounds back to dollars (£360,000 x 1.4) = $504,000
Using arbitrage trading, the investor makes a profit of $4,000 ($504,000 minus the initial investment of $500,000).