What is Arbitrage?

Arbitrage is all about taking advantage of “the cookie scenario”...

An arbitrageur is kind of like someone who buys cookies for cheap from a bulk supplier, then sells them for a higher price at a bake sale. Arbitrage trading requires finding unique circumstances in different markets (for example, a foreign market) that cause the same goods to be priced differently. It usually requires in-depth knowledge of different markets and close observation of the news cycle. For traders, brokers, and other investors, arbitrage can be a way to make calculated profits. But this strategy also carries significant risks and isn't apropriate for most investors.

Arbitrage often involves trading in international markets. This typically starts with thorough researching and monitoring international news. Then, an arbitrageur will look for variability among prices in the markets. An arbitrageur then finds the precise moment to buy and sell stocks in different exchanges – Then, they make a simultaneous purchase and sale.

How do you trade with arbitrage? Let’s say a stock is listed in both the New York Stock Exchange and the Tokyo Stock Exchange. In this scenario, you could earn short-term cash by monitoring the price fluctuations and acting at the perfect moment.

Taking our bake sale analogy into the real world, imagine that your favorite international auto company’s stock is valued at 75.14 USD on the New York Stock Exchange (NYSE). On the other side of the world, on the Tokyo Stock Exchange (TYO), the value of this auto company is 6,853 JPY, or 64.70 USD. An investor could notice this, and take advantage of the time difference, the price discrepancy, as well as fluctuating demands and circumstances in each market, and simultaneously buy shares from the less expensive market and resell them in the market at a higher value. The precise timing of the arbitrageur’s trade will affect the price discrepancy of the two trades.

While the example above illustrates how arbitrage works, it's not a realistic example of profit you might expect with this type of transaction. When you account for the currency exchange rate, the profit on an arbitrage trade is more likely to be represented in pennies rather than dollars. As a result, it requires a significant upfront investment and large trades to make a lot of money.

Let’s say the investor buys 100 shares of this auto company's stock on the TYO to sell simultaneously on the NYSE. At a difference of 10.44 USD per share, you can see how this would be a profitable trade.

The examples are for illustrative purposes. Arbitrage is not appropriate for all investors. There is no guarantee that any strategies discussed will be effective.

Arbitrage trading is simple in theory, but nuanced in practice. There are many variables an investor needs to know before aiming for a short-term profit through arbitrage trading. You’ll need to have a thorough knowledge of different markets and price differences to be successful.

Because of this, arbitrage is more commonly executed by large financial institutions and sophisticated investors who have both enough resources and expertise. Arbitrage trading also requires a working knowledge of derivatives (contracts between two parties outlining conditions based upon the value of assets), margin trading (trading with borrowed funds to profit on future price differences) – not to mention a large amount of up-front cash.

Not all markets operate the same, and stocks have different values in foreign economies. Arbitrageurs follow these differences closely, then buy and sell strategically when they believe they can make a profit.

Arbitrageurs can contribute to increasing cash flow in the market, or the total amount of liquid money coming in and out of a market. They also help maintain efficiency in the marketplace because they draw attention to price discrepancies between different markets, which can help normalize prices.

Because arbitrage is based on real-time price differences, not projections of future value, arbitrage is a relatively straightforward tactic. But in practice, there are some variables at play that those investors who are suitable should consider when completing arbitrage trades (Note: Arbitrage isn't for most investors):

1. Arbitrage happens because of market inefficiencies and pricing errors. These can be unpredictable. Reading the news, studying markets helps, and building a deep understanding of stock markets can help improve an investor’s trading success.
2. Timing is everything in arbitrage. If you hold on to your shares while the markets correct themselves, for example, you could miss out on the price discrepancies you need to make a profit.
3. The foreign exchange rate and brokerage fees can undercut your expected profit. Investors need to factor these transaction costs into your calculations when attempting an arbitrage trade.
4. Owning any asset can be a risk, since stocks can lose their value.

You might be thinking that arbitrage seems like a lot of work for a small profit, and you may be right. Arbitrage isn’t guaranteed to generate returns, and is often only successful if you’ve done the research, feel confident in timing, and are in a financial situation that allows you to keep your eye on a short-term prize. As with any investment strategy, arbitrage involves the risk that whatever you purchase could lose its entire value.