Understanding Arbitrage

The term “arbitrage” or “arbitrage trading” might be one that you have heard but are not completely familiar with. If this is the case, then you are in luck! This article will outline the basics of what arbitrage is, how investors can use it as a strategy, and other real-world applications of it. First, it is important to understand what arbitrage is. In perhaps the most basic terms possible, arbitrage is the simultaneous (or nearly simultaneous) purchase and sale of something to achieve a profit. The strategy revolves around the ability to find one asset that is priced lower in one place than it is in another and exploit the price difference in order to make money. Ultimately, arbitrage exists because of market inconsistencies and as long as our markets are not perfect, there should be an opportunity for arbitrage. Not to worry, it is unlikely that our markets will be exactly perfect anytime in the near future. That said, arbitrage in the financial markets has become increasingly difficult due to modern technological advancements. In fact, many traders who practice an arbitrage strategy do so effectively by using computerized trading systems. These systems have the ability to monitor fluctuations in the market and make trades automatically — taking advantage of pricing inconsistencies within the few seconds that they exist. Interestingly, many professionals believe that arbitrage is a necessary aspect of the financial markets because it acts as a “corrector” of mispriced assets.

To help you better understand arbitrage trading, here is a relatively simple example of a situation where it would work. Imagine that there is a company (A) and its stock is trading on the New York Stock Exchange (NYSE) for $100.07 per share. However, at that exact same moment, Company A’s stock is trading on the London Stock Exchange (LSE) for only $100. Using an arbitrage strategy, a trader could buy the stock on the LSE and immediately sell it on the NYSE for a profit of $0.07 per share. While $0.07 per share might not seem significant, when traded in large quantities smaller differences can add up to create big profits. Additionally, the ability to make such trades would continue until the opportunity no longer exists once specialists realize the mistake and the prices are adjusted. For a brief window of time, though, a trader would have the opportunity to exploit this advantage to the best of their ability.

While arbitrage is a term that is most likely to be used within the context of the financial markets, there are other ways this concept can be relevant in your life. For instance, there has been a rise in a trend called “retail arbitrage” over the past few years. Retail arbitrage is a term used to describe the action of buying something at a retail store (in person or online) for a certain price, with the intention of selling it for a profit somewhere else (usually online). For example, if you were to go to an overstock store such as TJ Maxx, Marshalls or Nordstrom and find a name brand pair of pants that are on sale, but realize that the same pair is being sold on eBay for higher price, you could purchase them and potentially sell them that same day for a profit. In fact, people have come to find many different types of items that this works for —ranging from clothing to food, and even cleaning supplies. However, some websites such as Amazon have attempted to amend their selling policies to cut down on people exploiting these competitive advantages. That said, there are still many opportunities out there and they might be worthwhile to explore.

Arbitrage and arbitrage trading can be an extremely powerful, and perhaps necessary, tool for investors. Although many individual investors do not have the large sums of money needed to take full advantage of arbitrage opportunities in the financial markets, it is still an important concept to understand for when you do have more money in the future. Moreover, by having a firm understanding of what arbitrage is and how it works, you might be able to apply it to other aspects of your life for profit — even if you do not have access to large sums of money quite yet. Overall, broadening your understanding of financial markets and investing strategies will nearly always help you in the long run. The process of making informed investing decisions begins with increasing your knowledge of the subject!