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What is the definition of arbitrage?

Posted on Monday, June 24th, 2019 by MarketBeat Staff

Summary - Arbitrage is a trading strategy that seeks to take advantage of a momentary price difference between an asset’s price on two different exchanges. A very basic example of arbitrage could look like this. A company’s stock is selling for $40 on the New York Stock Exchange and simultaneously at $40.05 on a different exchange (e.g. the Toronto Stock Exchange). An investor can profit by buying 100 shares of the company’s stock at $40 and simultaneously selling (or shorting) 100 shares of the stock at $40.05. The buyer then profits from the difference. In this case, their profit would be $5. These trades are typically executed very quickly so a trader could theoretically conduct dozens of these trades in a single day.

There are two basic types of arbitrage: pure arbitrage and risk arbitrage. The example above would be one of pure arbitrage. This means there is no downside risk since an asset is being bought and sold at the same time. The limitation of pure arbitrage is that many pure arbitrage opportunities are not available to retail investors due to the prevalence of high-frequency trading and computerized systems that are designed to process data very quickly.

Risk arbitrage means that the condition causing the price discrepancy may or may not occur. Therefore the trader is taking on the risk that a trade may not go the way they intended. An example of this occurs in mergers and acquisitions. Since the company that is acquiring the other company typically pays a premium for their shares, an investor can set up a trade to capitalize on this price discrepancy. The risk involved with this kind of trading is the possibility that the merger does not happen. In that case, the trader could be caught holding on to shares that may actually decline in price.

Although arbitrage is a proven trading strategy, it goes against the efficient market hypothesis (EMH) which states that a stock price includes everything that is known about a stock in real-time. The ability for computers to make trades in milliseconds does not refute the EMH but generates volatility to the market that investors have never had to consider before.

Introduction

As a strategic concept, the goal of arbitrage is no different than other forms of investing. Traders looking to buy an asset for a low price and sell it at a higher price. The difference with arbitrage trading is that profiting from this strategy involves entering and exiting trades in a very small window of time, frequently measured in milliseconds. In this article, we’ll break down the definition of arbitrage and break down the difference between pure arbitrage and risk arbitrage. We’ll close the article by reviewing the limitations of arbitrage trading.

What is the definition of arbitrage?

Arbitrage is a trading strategy in which there is an attempt to profit from momentary price differences that can develop when a security or commodity trades on two different exchanges. In order to do this, an arbitrageur buys in the market where the price is lower and, at the same time, sells in the market where the price is higher. Because of the need to execute trades quickly, usually with the assistance of arbitrage software, arbitrage is common among day traders.

Understanding the two types of arbitrage

There are two main types of arbitrage: pure arbitrage and risk arbitrage.

  • Pure arbitrage is said to be risk-free because it only occurs when a trader has confirmation that a price difference exists. Most pure arbitrage opportunities are labeled statistical arbitrage because the opportunities are data-driven. There is no attempt to assign meaning to the price difference. The only thing required for a statistical arbitrage opportunity is that a price difference exists.

    An example of pure arbitrage is when a stock trades on the New York Stock Exchange (NYSE) and the Toronto Stock Exchange (TSE) but they are simultaneously listed at a different price. If a trader feels that the higher price reflects the stock’s intrinsic value, they can buy the stock on the exchange where the price is lower and at the same time sell it on the market where it has a higher price.

Another common example of pure arbitrage occurs in the foreign exchange (forex) market. This strategy involves buying and selling different currency pairs based on their current exchange rates. On a forex chart, a currency pair will be listed similar to this:

EUR USD 1.28

This means that one Euro is worth $1.28 U.S. dollars. In this example, the Euro is listed first, meaning it is the base currency (the currency to be sold) and the U.S. dollar is what is called the counter currency. In forex arbitrage, investors will look for triangular trades where they may trade three different currency pairs at three different banks with the goal of ending up at the original currency at a profit. For an investor to successfully execute an arbitrage currency trading strategy they will need access to real-time quotes and tools such as a Forex arbitrage calculator that let them identify opportunities within a short window.

The growth of the cryptocurrency market in recent years has created some pure arbitrage opportunities for retail traders. In the crypto market, it’s not uncommon for an asset (coin) to have higher trading volume (liquidity) on one market and less on another. Based on supply and demand, the coin on the lower volume exchange will command a higher price. By buying the lower priced coin and simultaneously selling the higher priced coin, traders can profit from the difference.

It if it sounds simple, it can be. However, any form of cryptocurrency arbitrage, such as bitcoin arbitrage, has systemic concerns that traders need to be mindful of. One of these is that many exchanges make it very expensive to withdrawal cryptocurrency and charge an additional fee to exchange it into another currency. These fees can easily take away any profits and, in some cases, turn a profitable trade into a losing one. Another systemic concern about executing arbitrage trades with cryptocurrencies is the blockchain technology that the currencies are built on. Blockchain makes these transactions very secure, but in exchange for that security a single trade can take over an hour to be confirmed. Since arbitrage is a multi-stage process, this can create difficulties since each step has to be confirmed before the next one can initiate.

It can be difficult for retail investors to profit from pure arbitrage opportunities. This is because most pure arbitrage opportunities are based on mathematical models, and institutional investors have the resources (in the form of computer systems and high-frequency trading) to swiftly identify and execute trades, effectively shutting out retail investors from the market.

  • Risk arbitrage is considered speculative because it relies on events that may or may not occur. Whereas pure arbitrage is almost entirely data-driven, risk arbitrage involves having investors evaluate an opportunity based on the probability of an event taking place. There are a number of categories of risk arbitrage that are common for investors. However, a few of the most common are cash-and-carry arbitrage, merger arbitrage, and relative value arbitrage. We’ll take a closer look at each of these below.

  1. Cash-and-carry arbitrage– This is a variation on a pure arbitrage play that involves an asset being price on the spot market at one price and on the futures market for a higher price. For example, if Company XYZ is selling at $80 per share with a one-month futures contract priced at $84. An investor would take a long position by buying the stock at $80 and, at the same time, selling the futures contract (i.e. shorting it) at $84. The investor then holds or “carries” the asset until the contract’s expiration date and delivers it against the contract for a profit. The reason why this falls under the category of risk arbitrage is because of the expenses (storage, insurance, and financing costs) that are associated with carrying the futures contract.

  2. Merger arbitrage– Mergers and acquisitions (M&A) activity is an opportunity for arbitrage trading. This kind of trading was popularized in the 1980s when M&A activity was at a peak. In an M&A trade, the acquiring company will typically announce that they are buying the company they are acquiring at a premium to their current share price.

    For example, Company XYZ announces they are going to acquire Company ABC. Company ABC currently sells for $30 per share, but Company XYZ announces they will pay $40 per share in order to take control of the company. Despite this announcement, the market will not price Company ABC at $40 but instead may choose a number that reflects the risk of the merger not being successful. If they believe the merger still has a 90% chance of occurring, they may price the stock at $36. At the same time, if Company XYZ was trading at $30 per share before the announcement, the market will push down the stock price to reflect the same risk, for this example $27.

    In a merger arbitrage trade, a trader would take a long position on Company ABC at a price of $36 and open a short position on Company XYZ at $27.

  3. Relative Value Arbitrage– this form of arbitrage assumes that if two assets (usually stocks) have a historically high level of correlation and one moves significantly above or below the other, a trader could take the opportunity to short-selling the company that was rising above the other and buying the other company on the theory that over time the two stocks will revert to the mean, thus bringing the prices into a closer correlation.

Limitations to arbitrage trading

As mentioned above, one of the limitations to pure arbitrage trading is that this era of big data puts a premium on high-frequency trading and computerized systems. This makes it difficult for retail investors to execute an arbitrage investment strategy. Institutional investors, such as a hedge fund, have the resources to identify minute price discrepancies and execute trades when these discrepancies exist, even if only for fractions of a second.

However, one of the biggest limitations to arbitrage comes from investors who believe in the efficient market hypothesis (EMH). According to the EMH, everything about an asset’s share price is factored into the market in real time. Therefore, advocates of EMH would say there is no possibility for the market inefficiencies that are required for an arbitrage trade to occur. Similar theories to the EMH include the Purchasing Power Parity (PPP) theory which is a generalized version of the law of one price (LOOP) theory. Both theories postulate that a basket of identical goods (including currencies) should have the same price when expressed in a common currency.

The final word on arbitrage

Arbitrage in one form or another has been around for centuries. In its simplest form, arbitrage is a trading strategy that exploits differences in the price of an asset by simultaneously buying an asset for the lower price and selling it for the higher price. Because the asset is bought and sold at the exact same time, the benefit of arbitrage as an investment strategy is that it offers investors a risk-free return. However, this also means that for many retail investors, the majority of “pure” or risk-free arbitrage opportunities are not available to them. This is because the opportunity to take advantage of these trades requires high-speed trading and mathematical models that find the discrepancies in data that cause these price differences. The growth of cryptocurrencies has created an opportunity for pure arbitrage opportunities because blockchain technology allows the price differences in a coin from one market to another to last longer. Retail investors can also profit from forms of risk arbitrage such as the kind that happens with mergers and acquisitions. However, some would say this is not arbitrage in its “pure” sense – because there is a chance that the underlying reasons for the price difference will not stay in place (i.e. a merger that falls through).

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