BusinessHABTactical Arbitrage Training: Arbitrage is one of the oldest investment strategies. It’s important for traders to monitor activity on the market and note fluctuating prices of various assets. Knowing how to identify arbitrage opportunities can allow you to gain profit when conducting trades of stocks and other items. In this article, we discuss the definition of arbitrage, how it works and the trading conditions necessary for arbitrage to take place.
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What is arbitrage?
Arbitrage is a financial process that occurs when someone sells the same asset in two different markets simultaneously, one at a higher price than the other. Arbitrage allows investors to gain profit in the difference between the two market prices. The pay-off investors receive may be large enough to cover the cost of simultaneous transactions.
1. The background:
Arbitrageurs are professionals who practice arbitrage. They sell assets such as:
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Stocks
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Bonds
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Derivatives, including futures contracts and forwards
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Commodities, such as grain, oil or natural gas
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Currency, such as USD or Euros
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2. Identify an opportunity. The first step is to find a discrepancy in the market, which means spotting the value of an item that’s lower in one market than it is in another market. Arbitrageurs may work at financial institutions that use algorithms or specialized software to scour the market and quickly take advantage of price differences.
3. Review the transaction costs. Examine how much it will cost to make the sale. If the price of transaction matches or exceeds the price difference, then it may be challenging for you to benefit from the profit. For example, if there is a $2 price difference, but it costs $2 to sell the product on both markets, then you have no profit to gain.
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4. Purchase the asset. The next step is to buy the asset at its lower market price. For instance, if stock from a website company is cheaper on New York Stock Exchange (NYSE) than it is on the Toronto Stock Exchange, then it may be helpful to purchase it on the NYSE.
5. Sell the asset. To profit from the price difference, it’s important to sell the asset at the same time you purchase it. Otherwise, your trade may experience risks. For example, if the asset’s cost on one market decreases, then the price difference decreases, which limits your profit margin.
6. Pocket the profit. Once the trade is complete, you can gain profit from the price difference. Arbitrageurs with substantial monetary resources can secure large amounts of money from profits, since they can trade hundreds of shares at one time.
Trading conditions for arbitrage
There are three conditions where arbitrage can take place. They are:
7. The same asset has different prices on different markets. Markets may value an asset differently, which causes two unequal prices. If the prices for the same commodity are the same, then it may not be possible for the arbitrageur to gain a profit, which is why a discrepancy between markets is essential.
8. Two assets with the same cash flow have different trade prices. Some markets may perform at a higher quality than others, which can lead to price discrepancies. For example, if the Shanghai Stock Exchange experiences a downturn, then its prices may contrast from the prices on the NYSE for the same asset.
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9. An asset with a known future price holds a different price today. The prices of stocks and other commodities may increase with time, and they may appear on the market at a discounted price. The inefficiencies on the market present an arbitrage opportunity.
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Risks for arbitrage
As an investor, you may experience the following risks when practicing arbitrage:
10. Competing trades: Competition in the market can influence the success of an arbitrage transaction. If multiple people purchase and resell goods to the same markets, only one investor can benefit from the profit. If you’re an individual arbitrageur, you may compete with companies who use specialized technology to exploit market discrepancies within seconds.
11. Mismatched assets: Suppose you buy and resell two assets that are different and not identical. You risk losing the profit that you had expected to gain, and you may have to sell the assets at a loss.
12. Failed resale of the asset: When you purchase the asset, there’s a chance you may not resell it, which causes you to lose your profit. Failed resale’s may occur in financial crises, such as stock market crashes.
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Types of arbitrage
Arbitrage can manifest in several forms, such as:
13. Spatial arbitrage: The investors search for opportunities within markets in different locations. For example, they may find stock for a restaurant chain for a price in one state and a different price in another state.
14. Cross-border arbitrage: Arbitrageurs take advantage of price differences from markets in different countries. For instance, the cost of an asset may be higher in Tokyo than it is in America.
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15. Triangular arbitrage: Traders notice a difference in the exchange rate of currencies in three foreign countries. They convert a sum of money into the currency of one country, convert it again to another currency, then convert back to its original currency, gaining the profit. For example, the trader would convert USD to Euros, Euros to JPY, then JPY back to USD.
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16. Examples of arbitrage
The following examples illustrate the arbitrage process:
Example 1
The stock for a phone company trades for $25 on the NYSE. At the same time, it trades for $25.50 at the Shanghai Stock Exchange. The arbitrageur buys the stock from the NYSE and immediately sells it on the Shanghai market, earning a profit of 50 cents.
Example 2
Impressionism is popular in Europe, so an Impressionist style painting costs $10,000 in London. It only costs $4,000 in America, where Impressionism is not as prevalent. The trader buys the painting for the cheaper price in America and resells it in Europe, which rewards a profit of $6,000.
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Example 3
A trader has 1 million Canadian dollars (CAD), and there are three different currency exchange rates at three different banks. The first bank converts CAD to Euros at a rate of 0.67. The second bank converts Euros to USD at a rate of 1.20. The third bank converts USD to CAD at a rate of 1.25.
The trader converts the 1 million at the lowest rate from the first bank, which results in 665,245 Euros. Next, they convert the Euros into USD, resulting in $800,813. Finally, the trader visits the third bank and converts the USD back to its original currency, giving them 1,000,896.13 CAD. They earned a profit of $896.13.
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