What Is Arbitrage?

Arbitrage is an advanced trading strategy where traders open positions for the same asset in different markets. Learn more about the profitability of arbitrage strategy in this article.

Arbitrade in trading: Definition

Arbitrage is a trading strategy that takes advantage of price discrepancies for the same asset in different markets. Traders seek to profit from temporary variations in value.

It involves buying an asset (such as stocks, commodities, or currencies) in one market and simultaneously selling it in another market where the price is higher. The goal is to capitalize on the differing prices across regions or exchanges.

Types of arbitrage

• Spatial. This refers to exploiting price differences between different locations (e.g., buying cheaply in one city and selling at a higher price in another).
• Temporal. This strategy involves capitalizing on price variations over time (e.g., buying futures contracts at a discount and selling when they converge with spot prices).
• Statistical. This type is using quantitative models to identify mispriced assets based on historical patterns.

How does arbitrage work?

Traders identify situations where the same asset is priced differently in separate markets due to factors like exchange rates, supply and demand imbalances, or inefficiencies.

They execute rapid transactions to exploit these price differences.

For example, if a stock is undervalued on one exchange compared to another, a trader can buy it at the lower price and sell it at the higher price, locking in a profit.

Arbitrage example

Consider TD Bank (TD), which is listed on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE).

Assume TD stock trades at $63.50 CAD on the TSX and $47.00 USD on the NYSE. The USD/CAD exchange rate is $1.37 (meaning one USD equals $1.37 CAD). Calculating the equivalent value, each share should be $64.39 CAD on the TSX.

If a trader buys TD shares on the TSX for $63.50 CAD and simultaneously sells them on the NYSE for $47.00 USD, they make a profit of $0.89 per share ($64.39 – $63.50) after accounting for the exchange rate.

Is arbitrage profitable?

Arbitrage can be profitable, but it depends on several factors. Let’s explore them:

• Market efficiency. The profitability of arbitrage hinges on market efficiency. In highly efficient markets, price discrepancies are minimal and quickly corrected. In less efficient markets, opportunities for arbitrage may arise due to delayed information dissemination or other inefficiencies.
• Transaction costs. Even if price differences exist, transaction costs (such as fees, commissions, and exchange charges) can erode profits. Traders must consider these costs when evaluating potential arbitrage opportunities.
• Speed and timing. Successful arbitrage requires swift execution. Prices can change rapidly, so timing matters. High-frequency trading firms use advanced algorithms to capitalize on split-second opportunities.
• Risk. Arbitrage is generally considered low-risk, but it’s not risk-free. Market conditions can shift unexpectedly, leading to losses. Currency risk (exchange rate fluctuations) is also a factor in cross-border arbitrage.

Remember that while this strategy can yield profits, it requires vigilance, risk management, and understanding of the specific market conditions.

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