What is arbitrage?
Arbitrage is a strategy that takes advantage of these brief price mismatches by buying and selling in different markets. However, trading arbitrage strategies are complex and require a sophisticated approach. In this article, we'll expand on the definition of arbitrage, explain how price discrepancies occur in different markets and give examples of which arbitrage opportunities can benefit retail investors.
Overview of arbitrage
Arbitrage is a variety of trading strategies used to profit from temporary price differences when an asset is trading on different markets. Arbitrage is performed in various asset classes, especially where the same asset trades on multiple public exchanges. Arbitrage trading is risky since price variations are fleeting, and execution timing must be precise.
One of the oldest examples of arbitrage opportunities is trading a commodity like gold on different exchanges. Suppose a commodities trader noticed a momentary price difference between gold spot prices in New York and London. In the London exchange, gold trades for $1,800 per ounce. However, the New York exchange lists the price at $1,808. In this scenario, the trader can sell gold in New York while simultaneously buying gold in London and collecting the difference in the price in the two markets.
The mismatching of commodities prices like gold is a very basic example. Still, the strategy behind it can carry over into different asset classes like stocks, forex, cryptocurrencies and even real estate. In the next section, you'll learn about a few arbitrage investing and trading varieties.
Types of arbitrage
Here are a few of the techniques used in financial arbitrage. Note that these concepts have similar features, including the need to execute trades simultaneously to avoid market risk.
Spatial arbitrage is also known as geographical arbitrage, meaning a price discrepancy in markets in two different areas, like the example of gold in New York and London in the abovementioned paragraph.
Traders using spatial arbitrage take advantage of participants in different locations, not knowing the price the other is accepting.
Frequently, you must capitalize on these opportunities in seconds before other arbitrageurs notice the difference and initiate their trade, which will bring the prices back to equilibrium.
Temporal arbitrage allows traders to exploit price mismatches over time instead of location. Commodities that follow cyclical patterns, like oil or wheat, can often be used for temporal arbitrage trades.
For example, a trader that correctly anticipated an end to COVID-19 restrictions could have purchased oil futures contracts and profited from future price increases as Americans become itchy to travel and spend.
Statistical arbitrage (stat arb) is a mathematical trading strategy using massive portfolios employed mostly at hedge funds and other sophisticated institutions. However, stat arb originated as the simple 'pairs trade' involving two highly correlated securities, such as McDonald’s Corporation (NYSE: MCD) and Wendy’s Corporation (NASDAQ: WEN).
If MCD stock outperforms WEN, a pairs trader will buy WEN and sell MCD short in anticipation of their prices converging in the future. Stat arb strategies at institutions employ similar techniques over much larger scales.
Risk arbitrage is also known as merger arbitrage, a popular trading strategy from the 1980s when mergers and acquisitions of public companies were common and frequently volatile.
A risk arbitrageur looks for companies that are targets for a takeover. Since acquirers often pay a premium for their purchases, the risk arbitrage definition involves buying the shares of the takeover target while selling the acquiring company's shares. The risk in merger arbitrage is the agreement falling apart, which could send the takeover target's stock plummeting.
How does arbitrage work?
Markets are usually rational and efficient, but trillions of dollars and thousands of assets exchange hands daily. When so many transactions occur simultaneously, prices will inevitably slip. A trader selling shares of NVIDIA Corp. (NASDAQ: NVDA) may notice that prices are slightly different on NYSE in New York and TSX in Toronto and use arbitrage to profit off that price difference.
However, it's important to understand that arbitrage traders are necessary for efficient markets. Prices may be relatively inefficient, but thousands of transactions still create opportunities to exploit inefficiencies. But arbitrageurs act to quickly reduce these inefficiencies by pocketing the difference and equalizing prices. The edge disappears once the arbitrage trade executes, and prices regain efficiency.
Regulatory frameworks for arbitrage
Regulatory arbitrage refers to the concept where market participants can make advantageous decisions based on conflicting regulatory regimes. Tax, zoning and firm classification laws are some of the most common types of regulation businesses and institutions seek to work around. Ever ask yourself why so many companies exist in the Cayman Islands? If you guessed highly favorable tax treatment, you'd be correct!
Of course, regulators are aware of this concept (see this paper from Fordham University) and seek to close as many loopholes as possible. Businesses and traders need to understand their regulatory framework's complexities and ensure they stay on the right side of the law.
For example, Delaware offers businesses a huge perk with no state sales tax. Still, companies must have a registered agent located in the state and file all the proper paperwork (i.e., the foreign qualification form) to receive the tax benefits.
Arbitrage opportunities in financial markets
What is arbitrage trading in financial markets? Exploiting price differences across financial markets can be done in several fields and industries beyond typical capital markets. Here are a few nontraditional places where arbitrageurs can use their strategies.
Arbitrage in the real estate market
Companies like AirBNB Inc. (NASDAQ: ABNB) have opened a new avenue for real estate arbitrage. How does real estate arbitrage work? The same way any rental property works: receiving more in rental payments than monthly costs required for mortgage and maintenance. House flipping is another form of real estate arbitrage. An example of arbitrage is when an investor purchases a property for less than market value and resells it for a profit following a renovation project or rebound in local house prices.
Arbitrage in e-commerce and retail
E-commerce giants like Amazon.com Inc. (NASDAQ: AMZN) and eBay Inc. (NASDAQ: EBAY) allow retail investors to sell products for a profit over the internet. E-commerce sellers look for underpriced items to buy and resell on these platforms for a profit.
Arbitrage in e-commerce usually requires expertise in a particular niche or product line since you don't want to purchase items for reselling without a high degree of profit certainty. Wholesalers like Costco Corporation (NASDAQ: COST) and BJ’s Club Holdings (NYSE: BJ) buy items at scale for discounts and break them down for resale to club members.
Arbitrage in cryptocurrencies
Crypto arbitrage is new since cryptocurrencies have only been around for over a decade, but it's also easy for retail investors to participate. Many different cryptocurrency exchanges exist. Some are publicly traded, like Coinbase Global Inc. (NASDAQ: COIN), and other exchanges are private, such as Gemini or Kraken. Large-cap tokens like Bitcoin and Ethereum often trade at slightly different prices on different exchanges, but with smaller and more volatile tokens, the price gap can be more prominent. Crypto arbitrageurs can purchase tokens on the lower-priced exchange while selling on the higher-priced exchange and count the difference as profit minus any crypto-related fees. (And since it's crypto, there will always be fees.)
The risks and challenges of arbitrage
Ask someone to define arbitrage, and they'll usually mention "risk-free." While some forms of arbitrage take on minimal risk since the buy low/sell high trades are executed concurrently, you cannot fully eliminate risk. Sometimes, risk can become unmanageable if conditions exit the predicted parameters.
One commonly cited example of arbitrage disaster is long-term capital management (LTCM). LTCM engaged in stat arb, usually with bonds and currencies. The hedge fund had a leveraged portfolio of correlated assets and expected the spreads of its holdings to converge. But when Russia unexpectedly defaulted and devalued the ruble, LTCM's arbitration strategy exploded, and the company needed to be rescued and taken over by the government.
Arbitrage may reduce certain risks due to the short holding periods. However, transaction costs, liquidity issues, storage costs and regulatory concerns could be hidden risks that investors don't anticipate.
To engage in arbitrage trading, you only need a brokerage account and access to multiple exchanges (depending on the particular asset you want to trade). If you want to arbitrage cryptocurrency prices, you'll likely want to open an account at multiple exchanges and watch for momentary differences in spot prices.
Advanced arbitrageurs will want more sophisticated tools like automated trading bots. Since arbitrage opportunities are frequently measured in seconds (or fractions of a second), computer-enhanced trading is often the only path to success. You can't have your eye on every market corner at once, but scanners and automated systems (including AI-influenced programs) can seek out opportunities and pounce instantly.
Legal and ethical considerations
Arbitrage involves buying and selling assets in multiple markets. Domestic exchanges adhere to the same regulatory blueprint, but arbitrage often involves buying and selling assets across borders or jurisdictions. In the gold example listed above, what different laws and regulatory rules may exist between London and New York?
When trading assets across exchanges, you must consider key aspects like taxes, penalties and legal rulings. Compliance can be a problem when legal status and ethical concerns are murky. Ensure you know the laws for every market you're trading in.
Arbitrage vs. investment: Which is better?
Investing will be better than arbitrage trading for all but the most sophisticated traders. Arbitrageurs must constantly seek new information and look for price mismatches across assets. This means living the day trading lifestyle, with hours spent in front of screens looking for opportunities. Unless you can program automated systems to handle the transactions, consistently finding arbitrage opportunities is a tough ask.
Plus, consider your opposition to arbitrage trades. You'll be up against some of the world's most technically proficient hedge funds, with a massive advantage in research, training and computational power. And even then, they don't get every trade right. For everyday savers or retail investors, buying and holding index funds in a 401(k) account or IRA is a simpler and more efficient way to earn a return.
Arbitrage strategies for beginners
The easiest way for beginners to get started in arbitrage trading would be through pairs trading, whether through stocks, commodities or currencies. For example, think of two companies in similar industries that do well in certain economic conditions, like Home Depot Inc. (NYSE: HD) and Lowe’s Companes Inc. (NYSE: LOW).
When the economy is strong, and homeowners want to improve their property values, do-it-yourself (DIY) home projects can boost the sales of these consumer discretionary companies. In this particular trade, let's say that HD was underperforming LOW compared to expectations. In this scenario, a pairs trader would buy HD stock and short LOW, anticipating prices to converge with either LOW dropping or HD rising.
Arbitrage trading requires speed, skill and intimate market knowledge
The definition of arbitrage may be easy to grasp, but the execution is far more challenging to pull off. Arbitrage occurs because markets have inefficiently priced assets. However, these inefficiencies are fleeting and taking advantage of them requires a quick and experienced hand. That's because you're competing with the most sophisticated trading institutions in the world, and it's unrealistic that any retail trader would be able to spot price mismatches faster (or at a higher rate) than the world's top asset traders. Also, arbitrage trading often contains hidden risks that may not be readily apparent to inexperienced investors.
The bottom line is, to have success with arbitrage trading, you need detailed knowledge and instincts about a particular asset class, the speed to execute the arbitrage trades and the skill to size your positions appropriately and manage risk. Opportunities seem more frequent than ever with cryptocurrency now mainstream accessible, but arbitrage still requires a lot of work to get right.
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