About Arbitrage Trading
Arbitrage in its simplest form, according to experts, is the exploitation of price inconsistencies within different markets of similar or identical assets. The goal is to make a profit from this discrepancy before it is corrected.
The simplest form of arbitrage trading is buying an asset in an exchange or market where the price is lower and, at the same time, selling it in the market where the asset’s price is much higher. It is a widely used investment and trading strategy and considered as one of the oldest strategies that ever existed.
A report defines arbitrage trading as, “a trading strategy that takes advantage of pricing differentials in different markets and exchanges of the same asset.” For an arbitrage opportunity to happen, the Alpha Roc report continues, there has to be a situation where there are two equivalent assets that have different pricing.
Real life examples of arbitrage can be found in spaces like the foreign exchange market, cryptocurrency trading, company offshoring, and even sports betting. Because of the diverse nature of arbitrage trading, and the fact that it involves “exploiting” market indiscrepancies, new traders often ponder the legality of the practice.
Arbitrage trading is not only legal in the United States, but is an encouraged practice, because it contributes to market efficiency.
Two Major Advantages of Arbitrage Trading
Arbitrage Trading and Market Efficiency
By attempting to benefit from price discrepancies, traders who engage in arbitrage can be said to be contributing towards market efficiency.
A standard example of arbitrage would be an asset that trades in two different markets at different prices.
A trader can profit from this pricing difference by buying the asset at the market that offers the lower price and selling it back on the market that purchases at the higher price.
These profits, after accounting for any additional costs, will attract the attention of other traders who will want to exploit the same price inconsistency, and as a result, the arbitrage opportunity will disappear. This opportunity will disappear because as more traders attempt to make their profit on this inconsistency, the prices of the asset will balance out across the markets.
Concerning international finance, this convergence will lead to purchasing power parity between different currencies.
Consider this example:
If the same type of asset is cheaper in France than it is in England, British citizens would travel over the border to purchase the asset, while the French would purchase the asset, bring it to England and resell it in the English market.
In order to facilitate the transactions, British citizens would have to purchase Euros (EUR), while selling British Pounds (GBP) in order to buy the asset in France, and the French would have to sell the GBP that they received from their sales of the asset in England to purchase EUR to spend in France. These actions will lead to the appreciation of the Euro and the depreciation of the dollar currency in relation. Thus, over time, the advantage of purchasing this asset in France will dissipate until the prices converge.
Lower-Risk Trading
The biggest benefit of doing arbitrage is that the risk element is close to nothing.
For example, if an international company, with several branches across the globe, is listed in stock markets of New York and London and in New York market it trade at $200 and in London market it trades at €220 and exchange rate is $1 = €2 than ideally it should trade in London markets for much more.
Now a trader thinking of doing arbitrage would sell stock in the New York market and purchase the same stock in the London market. Considering this, it means that this trader would be able to make profit at a much lower risk.
As mentioned, arbitrage trading works due to and thrives off of the inefficiencies within the market. Alpha Roc further elaborates that the supply and demand, of a given asset, are the primary driving factors behind financial markets, and a change in either of them can impact the prices of the assets.
It is an arbitrage trader’s job to take advantage of these momentary glitches brought about by the inefficiencies in order to make a profit.
This, however, does not need to be done manually. Traders can make use of an automated trading system to help them benefit from the full advantages of an arbitrage trading strategy.
An Important Concern to Consider
One factor that many individuals fail to take into consideration is the additional costs that come with arbitrage trading. There are transaction costs and taxes associated with buying and selling of an asset which in turn, if not considered, can result in an incorrect estimation of profits and may even lead to loss if price difference is not much.
Simply put, arbitrage trading is not for the greedy.
Realistically speaking, there are also not that many arbitrage opportunities to take advantage of, and in the event that a few are found, a trader must have the latest technology in order to take positions quickly.
These automated trading systems utilize algorithms to spot pricing gaps, allowing traders to jump on an exploit in the markets before it becomes common knowledge and the markets adjust the pricing.
A trader must also have the expertise to make such transactions and come out on top.
To meet these requirements, a great deal of time and money is needed in order to do arbitrage.
The Bottom Line
There is no doubt that arbitrage trading can be a strategy that brings in great returns, but it is important that due diligence is done before attempting to make profits.
If the appropriate amount of practice is taken (studying, analysis, and consulting experienced experts in arbitrage trading), this can be an excellent strategy to use in all market situations.