What is Arbitrage?
There are plenty of investing strategies out there — But arbitrage is a short-term investment tactic in which an investor aims to profit by purchasing an asset while simultaneously selling that asset at a higher price in a different marketplace.
While investors chase profits in their own market, sometimes an opportunity lies in a different marketplace — The combination of the two is a tactic known as arbitrage. Some investors aim to use arbitrage to profit in the stock market after careful research and calculations. Arbitrage trading is when an investor simultaneously buys and sells assets in two different markets where the asset has different values, then pockets the difference. Like all trading, when it comes to arbitrage, timing is everything. Investors who practice arbitrage are called arbitrageurs, and they typically trade their choice of stocks, shares, or cryptocurrencies. In fact, Arbitrage trading helps keep markets efficient because it draws attention to price discrepancies between different markets, which can equilibrate prices.
Arbitrage trading is kind of like working at a bake sale when you don’t like to bake. Imagine you buy a tray of cookies at Costco for $0.25 per treat, and you turn around and sell them at a crowded bake sale in another neighborhood for $1.00 each. You saw an opportunity: The value per cookie in the Costco tray was lower than the value per cookie when sold across town at the bake sale. When this happens in the stock market, it’s called arbitrage trading. An arbitrageur finds arbitrage opportunities in different markets like this bake sale scenario. Only instead of buying and selling cookies, arbitrageurs can trade stocks and bonds. This strategy, known as arbitrage, is used by sophisticated investors seeking short-term profit that can help add liquidity, or cash flow, to a long-term investment plan.
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. Although it carries its own risk of purchasing an asset to sell in the future with no guaranteed returns – It's not 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.
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 to 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):
There is a practice called credit card arbitrage that follows many of the same principles as arbitrage trading, and is similarly risky. Let’s say you were offered an 18-month 0% APR offer on a new credit card with low cash advance fees. After you apply for the credit card and are approved, you could cash out your limit and invest the money. You’d only do this if you were confident that you would earn more than enough to pay back the money and any cash advance fees within the promotional period. After 18 months, you might earn enough to profit on your investment before paying back the card.
It’s important to know that there are other risks associated with credit card arbitrage, separate from losing your invested money. For example, any interest earned on your investment is considered taxable income, so it’s important to factor in taxation costs when estimating returns. In addition, maxing out a credit card usually impacts your credit score, as does missing a payment deadline.
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. 20191129-1023946-3085449
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