What Is Arbitrage?
It refers to a trading strategy based on purchasing a commodity, including foreign exchange, in one market at one price while simultaneously selling it in another market at a more advantageous price to obtain a risk-free profit on the price differential.
According to the new business dictionary,” Arbitrage is swapping or switching over funds from one investment to another, taking advantage of the differentials to maximize gains.”
In the financial market, price variance is expected due to market inefficiencies, disparities in supply and demand, or differences in market structure or regulations. Because of this reason, traders use this strategy to take advantage of the price differences of the same commodity, assets, or security.
More Thorough Understanding of the Term
Arbitrage means finding two things that are essentially the same, buying cheaper and selling or selling short, the more expensive. People who take advantage of this strategy are called “Arbitrageurs.” Arbitrageurs hope to gain profit by buying a commodity or asset in one market where the price is low and selling it at a higher price in another market. The difference between buying and selling is the profit they gain.
Yet, arbitrage possibilities are frequently short, as market participants respond fast to exploit and eradicate price disparities. When the arbitrageur buys the stock on the NYSE and sells it on the TSE, the higher demand on the NYSE pushes up the price, while the increased supply on the TSE drives down the price, finally eliminating the price gap.
This strategy can be used in various markets, such as bonds, stocks, or currencies. It can also be applied in trades such as cash and carry Arbitrage. In cash and carry Arbitrage, traders buy and sell the underlying asset in a future contract. Sometimes traders employ reverse cash and carry Arbitrage, selling the underlying assets and buying the future contract.
How Does Arbitrage Actually Work?
The basic idea of this strategy is to buy low in one market and sell high in the other, gaining a profit from the price difference. Here’s a complete step by step process explanation of how it works:
- In the first step, an arbitrageur monitors different market prices and demands the same asset and security. This involves comparing them to various exchanges, markets, and trading platforms.
- Once the price discrepancy is identified, the arbitrageur buys the security from the market or platform where the price is low. This involves placing buying order for that particular security on an exchange or trading platform.
- In the third step, the arbitrageur sells the security immediately and simultaneously where the price is high. This involves placing various selling orders for the security on a different trading platform or stock exchange.
It is essential to note that market conditions change rapidly as unexpected events can lead to losses, which is why Arbitrage is not risk-free. Only experienced traders with sufficient knowledge and resources can efficiently execute arbitrage strategy.
Examples
Let’s say that the exchange rate between USD and EUR is $1.10 in NYSE. On the other hand, in LSE, the price difference between USD and EUR is $1.12. An arbitrageur can take advantage of this situation by doing the following:
- In NYSE, the arbitrageur buys Euros for $1.10 per Euro and invests $1 million. He got 909,091 Euros on hand now.
- The arbitrageur immediately sells the Euros on LSE for $1.12 per Euro. He received $1,018,182 for selling 909,091 Euros.
- The price difference between buying and selling is the profit he made.
Another exam is, buying and selling multiple currencies simultaneously.
- Sell euros to buy dollars
- Sell dollars for pounds
- Sell pounds for euros.
In Sentences
- Arbitrage traders exploit price differences by monitoring and identifying opportunities in various markets.
- In the process of doing Arbitrage, the traders boost the efficiency of financial markets.