What Is Arbitrage Trading?
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There are many different types of arbitrage trading. All involve simultaneously buying and selling financial security in different markets with the purpose of realizing a profit from small price differentials.
Properly executed basic arbitrage trading, such as market arbitrage, produces an immediate, risk-free profit.
Much of today’s arbitrage trading has been made possible by two relatively recent developments. The first is the advance in technology that makes arbitrage trades easier to identify and execute. The second is the increased interconnection that exists between different financial trading markets all around the world.
Related: Free Day Trading for Beginners Guide
What Is Arbitrage Trading
What if you could buy a stock or other financial security in one market and immediately sell it in another one for a higher price? With arbitrage trading, you can.
The foundation of arbitrage trading is owed to the fact that financial trading markets are not always perfectly efficient. If they were, all financial securities would always trade at exactly the same price in every market. However, the reality is that small, temporary market price inefficiencies arise where the same asset is briefly trading at slightly different prices in different financial markets. Arbitrageurs exploit such temporary price inefficiencies for profits.
Because the price differences are typically minimal, an arbitrageur must trade very large positions to make any substantial profit. Thus, arbitraging requires a large amount of trading capital.
For that reason, arbitrage trading is, for the most part, solely the domain of large institutional traders that have the necessary amount of money. Hedge funds are among the most common arbitrage traders.
An additional reason that arbitrage trades are mostly limited to traders at large financial institutions is that identifying arbitrage opportunities and then executing arbitrage trades before the opportunity disappears usually requires very sophisticated and very expensive day trading software with coded high frequency trading (HFT) algorithms.
Arbitrage opportunities are only very briefly available precisely because there are arbitrage traders. Once arbitrageurs act on an opportunity, the buying pressure they add in one market and the selling pressure they add in another market quickly equalize the security’s price in both markets, erasing the temporary market inefficiency.
Necessary Conditions for Arbitrage Trading
In addition to a slight price differential between markets, two conditions are necessary for profitable arbitrage trading.
First, the transaction costs for making the two buy and sell trades must be very low – low enough that there is still a net profit remaining after deducting all the trading costs. If, for example, there is only a five-cent differential in the price of stock between the New York Stock Exchange (NYSE) and the London Stock Exchange (LSE), and transaction costs for the arbitrage trade would be six cents per share, then the trade cannot be profitably executed.
The second condition for executing a profitable arbitrage trade is that the traded security must have sufficient liquidity in both markets to keep the bid and ask spread very small. Again, this is because the price differential is very small. A wide bid-ask spread could nullify any potential profits.
Arbitrage Example – The New York Stock Exchange vs the London Stock Exchange
Here’s an example of a basic arbitrage trade:
Stock A is trading at $17.00 a share on the NYSE and at $17.10 on the LSE. An arbitrageur buys the stock on the New York exchange, immediately selling it on the London exchange. They pocket a quick 10-cent per share profit, minus trading costs. Admittedly, 10 cents isn’t much money. However, if the trader has the necessary capital to trade 100,000 shares, then the profit would be $10,000.
Making a $10,000 profit in about half a second is a pretty good rate of return. However, the profit only remains if both trades can be closed at an equal price, which is most likely since markets are often in sync. In our example, the long trade from $17.00 at NYSE would be closed at $17.00, and the short trade on LSE at $17.10 would be closed at $17.00 too.
Types of Arbitrage
Traders can conduct dozens of different types of arbitrage trading, while the vast majority of arbitrage trades can be categorized within just a handful of types.
Market Arbitrage/Cross-border Arbitrage
Market arbitrage, also referred to as cross-border arbitrage or spatial arbitrage, is the basic type of arbitrage illustrated in the example above. An arbitrageur simultaneously buys a security that is trading at a lower price on one trading exchange while selling short the same security trading at a higher price on a different exchange. As a result, an instant profit is realized, equal to the spread between the two different market prices, once both positions are closed at an equal price.
Another form of market arbitrage is index arbitrage, where differentials in the trading price of a market index, such as the S&P 500 Index, on different exchanges are exploited for a profit.
Statistical Arbitrage/Relative Value Arbitrage
Statistical arbitrage, sometimes referred to as relative value arbitrage, is another type of arbitrage that is less than totally risk-free. It is, however, considered to be a very low risk trading strategy. This strategy aims to profit from trading two securities whose prices have historically been very closely correlated.
Closely correlated stocks are often found within the same industry. For example, the stock prices of two large oil companies, such as Chevron (CVX) and Exxon (XOM), might tend to move relatively in tandem. When there is a substantial deviation from the normal price relationship between the two securities, an arbitrageur will look to buy the underperforming stock and sell short the overperforming stock in the expectation that the price spread between the two securities will eventually revert to its historical mean average.
This type of arbitrage is also commonly called “pairs trading” and is typically conducted using intricate mathematical models to predict the probability of the historical price correlation being restored.
Currency Arbitrage
Currency arbitrage is a popular arbitrage trading strategy because of two basic facts. One, the foreign exchange (forex) market is an over-the-counter (OTC) market rather than a trading exchange market. Combined with the fact that forex trading is highly liquid and active, arbitrage opportunities tend to arise much more frequently than they do in exchange traded securities markets.
Basic currency arbitrage works the same as market arbitrage. That is, a trader looks for opportunities to profit from simultaneously buying and selling a currency pair, such as EUR/USD, that is trading at slightly different prices in different markets or through different brokers.
Triangular Arbitrage
Triangular arbitrage is a more complex form of currency arbitrage that involves trading not two but three different currencies. It is executed as follows: The trader converts currency A into currency B, then converts currency B to currency C, and, finally, converts C into currency A. Assuming the trades are flawlessly executed, slight differentials in currency exchange rates mean that the trader ends up with more money in terms of currency A than they started out with.
Such a complex trading strategy, and one that usually requires making three transactions at three different financial institutions within mere seconds in order to profit from a fleeting market inefficiency, can only be implemented with the aid of high-speed computer algorithms. It is also dependent on extremely low trading costs for a worthwhile profit to be realized.
Convertible Arbitrage
As the name suggests, Convertible arbitrage involves trading a convertible security against its underlying stock. The arbitrageur buys the convertible security, such as a bond or option that may be converted to common stock, and sells short the underlying stock – or vice-versa, buys the stock and sells short the convertible security. This is another arbitrage trading strategy that requires a sophisticated computer program, first to find the opportunity and second to execute the trade before the temporary mispricing between the two securities evaporates.
Convertible arbitrage is sometimes referred to as capital structure arbitrage, when it aims to profit specifically from temporary price inefficiencies between different types of securities that make up a company’s capital structure – for example, between stocks and bonds that the company has issued.
Retail Arbitrage
Retail arbitrage might be referred to as “real world arbitrage,” as it involves trading real world products or services rather than financial securities. It is also one of the few types of arbitrage that are readily available for ordinary individuals.
Retail arbitrage consists of buying something and then selling it for a higher price. For example, you might be able to buy a product at a low price on eBay and then re-sell it on Amazon at a higher price, thus securing a profit. The key to expanding the profit is to keep the costs involved at a low level.
Merger Arbitrage/Risk Arbitrage
Merger arbitrage refers to arbitrage trades based on merger and acquisition deals. When one company seeks to acquire another company, it typically offers a premium price for the stock of the company being acquired. As a result, the stock of the company making the acquisition often falls, at least temporarily. That’s because it is making a significant expenditure and paying more than fair market value for the company it’s buying.
Traders can speculate by buying and selling stocks of those companies in the hopes that the prices correlate soon again.
However, some investors also speculate on the chances that the deal will fail or at least does not close out in the expected time range. Thus they also buy and sell shares of both companies against to make an arbitrage profit.
However, merger arbitrage is a risky one since mergers can go in different directions. For that reason, merger arbitrage is sometimes called risk arbitrage since, unlike market arbitrage, an immediate and risk-free profit is not guaranteed. The merger/acquisition deal may not be completed, and even if it is, the two companies’ stock prices may not move in the directions that the arbitrageur expects.
Other Types of Arbitrage Trading Strategies
As noted, there are many different arbitrage trading strategies. Some are used as an integral part of day trading strategies, and others aim for long-term profits. Here’s a brief rundown on some of the more common ones, in addition to those already detailed:
Futures Arbitrage/Cash Carry Arbitrage/Spread Arbitrage
There are several types of arbitrage trading that commonly take place in the futures market. Cash carry arbitrage, also known as cash and carry arbitrage, involves trading the spot price of a commodity against the commodity futures price. Spread arbitrage is similar to statistical arbitrage, or pairs trading, in stocks: It trades the spread between the price of two futures contracts that have different expiration dates.
Interest Rate Arbitrage/Fixed Income Arbitrage
Interest rate arbitrage aims to profit from temporary price inefficiencies in the bond market – for example, buying a short-term bond while selling a longer-term bond.
Volatility Arbitrage
Volatility arbitrage is one of many arbitrage strategies used in the options market. It involves buying the less volatile asset between an option and its underlying stock while selling short the most volatile stocks or similar asset. Other types of options arbitrage aim to trade price discrepancies between call and put options with the same strike price or between options with different strike prices.
Negative Arbitrage
Negative arbitrage is actually “losing arbitrage.” It refers to a situation where the interest rate that has to be paid on money borrowed is higher than the rate of return where the money is invested. Thus, there is a net loss for the borrower/investor.
Arbitrage for Individual Retail Traders
I’ve noted that arbitrage is principally limited to large institutional traders. However, it is possible for regular retail traders to obtain access to profits from arbitrage trading by investing in a mutual fund or exchange-traded fund (ETF) that engages in arbitrage trading.
Why Arbitrage Trading is Important
Arbitrage trading is important for three main reasons:
- Arbitrage strategies make it possible for traders to gain either risk-free or very low risk profits.
- The trading activity of arbitrageurs helps to make the financial markets more efficient, as it serves to quickly eliminate price inefficiencies.
- Because arbitrage trades involve high relative volume trading, they help to increase liquidity in the markets, narrowing bid and ask spreads.
Types of Arbitrage Summary
The opportunity to generate risk-free profits, or at least trade with very minimal risk, makes arbitrage trading strategies very attractive. So does the fact that various types of arbitrage can be applied across all types of financial markets (cryptocurrency arbitrage, for example, has recently become increasingly popular). Unfortunately, the required trading capital and complex computer software mean that most arbitrage trading opportunities can only be taken advantage of by banks, fund managers, or other institutional traders.
FAQ
What are arbitrage strategies?
Arbitrage strategies seek to use risk-free or very low risk trades to profit from temporary pricing inefficiencies in financial markets.
What is an example of arbitrage?
If a stock is trading at different prices on different trading exchanges, then a trader can profit by buying the stock on the exchange where it is priced lower and selling it on the exchange where it is priced higher.
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