Arbitrage Trading Capitalizes on Differences
Arbitrage trading is about as close to real-time, instant profit-taking as you can get. Rather than trade the price of a security in relation to itself, arbitrage capitalizes on the different value of the same security across markets. The great thing about arbitrage is that it applies to any type of security, so long as it’s cross-listed on different exchanges.
There are two types of arbitrage: pure and risk arbitrage. Pure arbitrage is the real-time exchange of securities for a profit. Let’s look at a very simple example:
The Widget Company (WGT) is listed on both the New York Stock Exchange (NYSE) and the Toronto Stock Exchange (TSX). At 1pm EST, the price of WGT on the NYSE is $34.67. At the same time, WGT is listed at $34.70 on the TSX. An arbitrage trader would buy shares on the NYSE and sell them on the TSX in real time to realize a $0.03 gain per share.
Risk arbitrage recognizes system inefficiency. Buyers buy a security anticipating an opportunity to sell when that inefficiency crops up. An example of risk arbitrage looks like this:
There is a rumor that Blue Widget Company (BWC) will buy Red Widget Company (RWC). RWC trades at $22 per share right now. Speculation says that BWC will pay $26 per share to acquire RWC. Retail traders can buy RWC at $22 and sell at $26 if this speculation comes to fruition.
These examples are very simplistic. While these cases do exist, arbitrage trading more often goes through several channels to realize price differences. It’s also common across different currencies, where one currency may have more buying power than another.
Exploiting Market Inefficiencies
Arbitrage trading is all about capitalizing on market inefficiencies. This could mean the difference between security prices on two or more exchanges. Or, it could mean leveraging the buying power of a different currency. Sometimes it even involves multiple types of securities.
Wherever there are minuscule differences in value, arbitrage traders will find a way to leverage them. Typically, this happens very quickly, since the market is dynamic. Since arbitrage trading deals in multiple markets, that means more volatility.
In theory, arbitrage seems like a low-to-no risk way to profit. If someone is willing to pay you $10 for something you bought for $9.90, how could you lose?
The reality of arbitrage trading is that it’s rife with risk. Time, as always, is the biggest risk. Markets may lag, but only by minutes or even seconds. As soon as prices update, the opportunity for pure arbitrage is lost. Trades must occur instantaneously before the window closes. If it does, arbitrageurs are left with the security at the price they paid for it with no way to offload it for a profit. In these situations, an arbitrage buy often ends in a swing trade or worse, a loss.
Unfortunately, most retail investors don’t have the opportunity to arbitrage. At least, not pure arbitrage. Market inefficiencies that lead to pure arbitrage are resolved quickly. Usually, only large funds and firms with automated trading software have the ability to cash in on pure arbitrage opportunities. Risk arbitrage is much more common.
Is Arbitrage Trading Legal?
Arbitrage trading is legal and even encouraged! Regulatory bodies see arbitrage as a form of market self-regulation. Exchanges are incentivized to keep prices as up-to-date as possible to prevent arbitrage opportunities. And, when they do occur, they promote market liquidity. Profits from arbitrage typically become reinvested in different securities.
There’s also the cross-border transfer of wealth to consider. Using the NYSE and TSX example from above, consider what arbitrage accomplishes outside of a profit-taking endeavor. If you buy a security for less on one market and sell for more on another, it creates a premium. The value of the security and the currency are subsequently transferred to the market it’s sold in. Here again, arbitrage incentivizes self-regulation to prevent the transfer of wealth out of markets.
Arbitrage Gets Complex Quickly
As mentioned, there are few pure arbitrage opportunities for retail traders. More investors are finding opportunities as they increase the number of mediums involved. The odds of inefficiency between two markets may be rare. The odds of inefficiency between three or four markets, or multiple markets and currency, are higher.
Consider triangle arbitrage, for example. This practice involves three currencies and three banks. Traders convert one currency to another at a lower rate, then to another currency at a higher one. Then, they convert currency back to the original for a small profit. Often, this happens at fractions of a cent difference, resulting in literal pennies on the dollar in profits.
Arbitrage traders may also purchase shares in one currency on an exchange and sell them on another, taking profits in a different currency. Small gaps in exchange rate result in marginal gains. Again, it’s a process that demands large sums of money to facilitate.
The Bottom Line on Arbitrage Training
Arbitrage trading is a great way to make profits at little-to-no risk, should you find the right investment opportunity. Pure arbitrage opportunities are few and far between for retail traders. If you do find yourself with a pure arbitrage opportunity, it’s as profitable as the inefficacy allows it to be. Risk arbitrage offers opportunity, but comes with, well, risk.
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Retail arbitrage is difficult to facilitate without an increasingly complex web of mediums. Traders need to be active on multiple markets or have the foresight to recognize systematic inefficiencies they can exploit. It takes work, but there’s low-risk profit in it for those who do the legwork.