Arbitrage

The practice of buying and selling an asset on different platforms or markets to profit from price differences. Basically, Per is selling apples for $3 per kilo. You buy a kilo. Then you go to Olle, who is buying apples at $3.1 per kilo. You just made 10 cents. Or, you buy a comb for $3, exchange it for a hammer, which you exchange for a screwdriver, which you exchange for a comb and a ribbon. Because a screwdriver is worth slightly more than a comb you also get the ribbon. Only, what you’re likely doing is exchanging USD to GBP to EUR to USD and end up with a little bit more than what you started with. Keep reading for a more in-depth understanding of arbitrage and how to make it work for you in the world of trading and crypto.

What Is Arbitrage?

Arbitrage is a trading strategy where traders take advantage of price differences for the same asset across different markets or exchanges. The goal is to buy the asset at a lower price in one market and simultaneously sell it at a higher price in another, locking in a risk-free profit. If you’re fast on your feet (switching screens) and know how to use a calculator, this might be for you.

How Arbitrage Works

Price Discrepancy: Prices for the same asset can differ across markets or exchanges due to variations in supply and demand, liquidity, or inefficiencies in price discovery. Arbitrageurs (not agent provocateurs…) look for these discrepancies whether it’s stocks, currencies, commodities, or cryptocurrencies to exploit the price gap.
Execution of Trades: The arbitrageur buys the asset in the market where it is undervalued and sells it in the market where it is overvalued. The difference between the buy and sell prices is the arbitrage profit. The key is that these trades are executed simultaneously or very quickly to avoid market risk (like price changes) during the process.

Real-World Arbitrage Examples

Stock Arbitrage (Cross-Exchange): Imagine Apple stock is trading for $150 on the New York Stock Exchange (NYSE) but for $151 on the London Stock Exchange (LSE). An arbitrageur can buy Apple stock on the NYSE and simultaneously sell it on the LSE, earning $1 per share in profit.
Cryptocurrency Arbitrage: In the crypto market, price discrepancies between exchanges are common due to varying liquidity and trading volumes. For example, Bitcoin might be trading for $29,000 on Binance but $29,200 on Coinbase. A trader could buy Bitcoin on Binance and sell it on Coinbase to capture the $200 price difference.
Triangular Arbitrage (Forex): In currency markets, triangular arbitrage occurs when a trader takes advantage of discrepancies between three different currencies. For example, if the exchange rates between USD, EUR, and GBP are not perfectly aligned, an arbitrageur can convert USD to EUR, then EUR to GBP, and finally GBP back to USD to make a profit without risking market fluctuations.

Types of Arbitrage

Spatial Arbitrage: Involves buying and selling the same asset across different locations or markets. This is most common in cryptocurrencies and stocks traded on multiple exchanges.
Statistical Arbitrage: This is more complex and relies on mathematical models to identify and exploit small price differences. It’s often used by hedge funds and high-frequency traders who rely on algorithms to execute thousands of trades in milliseconds.
Merger Arbitrage: Used during corporate mergers and acquisitions. Traders buy the stock of a company being acquired (which is usually underpriced due to uncertainty) and short the stock of the acquiring company to profit from the price difference once the deal is completed.

Challenges and Risks in Arbitrage

Execution Speed: Arbitrage relies on *simultaneous trades*. Any delays in executing the buy or sell orders can wipe out the profit due to market fluctuations.
Transaction Costs: Fees for buying and selling, such as brokerage fees, exchange fees, and transfer costs, can reduce or eliminate the arbitrage profit.
Liquidity Risk: In some cases, the market where you want to sell the asset may not have enough buyers, causing slippage (getting a worse price) or preventing the trade from completing.
Market Efficiency: Arbitrage opportunities are often short-lived as other traders spot and act on them, bringing the prices in line across markets. The more efficient a market, the less opportunity there is for arbitrage.

Key Takeaways

Arbitrage takes advantage of price differences for the same asset across different markets or exchanges.
It is typically a risk-free strategy if executed perfectly, but in practice, speed, transaction costs, and liquidity can present challenges.
Common forms of arbitrage include spatial arbitrage (across exchanges), statistical arbitrage (mathematical models), and merger arbitrage (during acquisitions).

In essence, arbitrage is about exploiting temporary market inefficiencies to lock in profits without assuming the usual risk of price movements. Traders who succeed at arbitrage are often the fastest and most well-informed, capitalizing on fleeting opportunities in the market.