What is Arbitrage Trading?
Arbitrage trading increases the efficiency of markets and can offer traders low-risk returns. Learn all about arbitrage trading in this article.
What is Arbitrage Trading?
Arbitrage trading is the practice of exploiting short-lived differences in the price of identical assets in different financial or non-financial markets. Arbitrageurs typically buy and sell an asset on two or more markets at the same time to profit from price discrepancies.
Arbitrage exists as a result of market inefficiencies arising from information asymmetry, varying transaction costs, and market psychology among other factors.
Arbitrage helps ensure that asset prices do not deviate significantly from fair value over long periods and enhances the flow of liquidity between markets.
Since market orders are usually filled immediately upon placement, they tend to be the most popular choice for arbitrage trades. However, it is not uncommon for arbitrageurs to also use limit and stop orders.
How does Arbitrage Work?
In arbitrage trading investors buy currencies, stocks, bonds, or any other financial or non-financial product to resell at a profit. Arbitrage takes advantage of short-lived variations in the price of identical or similar assets in different markets.
Arbitrage opportunities exist due to market inefficiencies. In a fully efficient market, all equivalent assets converge to the same price leaving no room for speculation. Market inefficiencies are commonly caused by the market's failure to consider all the factors affecting the price of an asset.
Arbitrage both takes advantage of market inefficiencies and resolves them. By narrowing the differences in price for identical assets across markets, arbitrage helps ensure that no assets diverge from their true value for prolonged periods of time.
Arbitrage trades can carry little to no risk, as they ideally imply no holding period.
In today’s world financial arbitrage is commonly done through computerized trading systems that automatically monitor fluctuations in similar financial instruments across markets and allow traders to act upon any inefficient pricing setups fairly quickly or make automated trades.
Different Types of Arbitrage
In triangular arbitrage, a trader seeks to profit from price discrepancies in three different assets at the same time. A triangular arbitrage strategy consists of three trades: exchanging the initial asset for a second, the second for a third and the third asset for the initial one.
Spatial arbitrage takes advantage of varying living costs across different geographical locations. Spatial arbitrageurs buy assets in countries with a weaker currency and sell them in locations with a stronger one.
Cross-exchange arbitrage is the practice of simultaneous buying and selling of assets across multiple traditional or crypto exchange platforms. The price of an asset may vary slightly between exchanges due to differences in transaction fees, trade volume and liquidity.
Merger arbitrage (or risk arbitrage) speculates on price inefficiencies associated with pending mergers or acquisitions between companies. A merger or risk arbitrageur typically takes a long position in the stock of the target company to reap the benefit of its possible future increase in price.
Retail arbitrageurs buy products at a discount from online or offline retailers and resell them for profit.
Arbitrage in Crypto
As with traditional arbitrageurs, crypto arbitrageurs capitalize on discrepancies in asset prices across multiple markets. They typically near simultaneously buy and sell cryptocurrencies on two or more cryptocurrency exchanges to cash in on market inefficiencies.
As digital assets are typically subject to higher volatility than fiat currencies, stocks, bonds, etc., the cryptocurrency market often offers more opportunities for arbitrage than the traditional financial system.
Arbitrage example (cryptocurrency)
Let’s say Bitcoin is trading on high-volume cryptocurrency exchange A at $23,045 per unit and on smaller-volume cryptocurrency exchange B at $23,040 per unit. Now let’s suppose there is an announcement in the media that drives up the demand for Bitcoin. Since exchange B usually sees less trading volume than A, it is likely to be slower to react to a change in the market. Thus, against the backdrop of the announcement, the price of BTC rises to $24,500 on A but only reaches $24,400 on B. If an arbitrageur acts quickly, they will be able to purchase Bitcoin on B for $24,400, sell it on A for $24,500 and make a profit of $100 per 1 BTC.
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Arbitrage pros and cons
- Risk-free profits.
Arbitrage trades generally come with little to no risk for an investor if they are able to buy and sell the asset near simultaneously.
- Little capital investment.
Arbitrage trading requires little initial investment capital.
- Fleeting opportunity.
Arbitrage narrows the spread between prices for identical assets in different markets and therefore reduces future arbitrage opportunities.
- Transaction fees and taxes.
It is crucial to consider transaction fees and taxes when performing arbitrage trades. Trading fees, withdrawal fees, network fees or exchange fees can influence the profitability of arbitrage or even cause losses.
- Price fluctuations.
If buy and sell transactions in an arbitrage trade are not closed at the same time, the risk of loss increases.
Is arbitrage trading illegal?
In most countries, arbitrage trading is not only legal but encouraged, as it contributes to market efficiency. Crypto arbitrage is legal across all jurisdictions that do not prohibit cryptocurrency trading.
Is arbitrage really risk-free?
An arbitrage deal can be considered risk-free if the buy and sell transactions are carried out simultaneously. However, it is also essential to take into account transaction fees and taxes when exploring arbitrage opportunities.
Is arbitrage profitable?
Arbitrage can be profitable. As long as inefficient markets exist, arbitrageurs will be able to earn yields. However, to generate substantial gains on arbitrage, investors are usually required to enter into high-volume trades, since asset prices rarely vary significantly from one market to another.
Why do arbitrage opportunities disappear?
Arbitrage both takes advantage of market inefficiencies and resolves them.