In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, it is the possibility of a risk-free profit after transaction costs. For instance, an arbitrage is present when there is the opportunity to instantaneously buy low and sell high.
Arbitrage is basically a trading strategy. It focuses on tapping profits from temporary differences of identical or similar assets, financial instruments or securities.
These temporary differences may result in short-term discrepancies due to market inefficiencies, thereby creating profit maximizing opportunities for investors and financial traders. Simply put, traders take advantage of slight price differentials to make profits over time.
This technique is often manipulated by traders operating in the stock market. Here’s how:
Some traders often buy stocks on Forex where prices for stocks have not adjusted to the fluctuating rate of exchange. Therefore, the stock price on Forex is undervalued in comparison to stock prices in the local stock exchange market. The trader basically taps on this small difference to make profits.
Since the market seldom remains perfect, arbitrage opportunities arise quite often. However, they are most certainly short-lived. So traders must take decisions in real time to maximize returns and enhance profits from price differences.
Minor price differences in this context refer to temporary discrepancies that may occur between a stock’s market value and its intrinsic value. Quick moving traders who are actively seeking for such discrepancies tend to make good profits over time by strategically benefiting from arbitrage opportunities.
Arbitrage can be divided into two different types:
The major difference between these two types of arbitrage is that Pure Arbitrage is free from risk, while the Risk Arbitrage is speculative. The Risk Arbitrage is defined as speculative because it is largely based on presumptions regarding future events, which sometimes, may or may not actually occur, so the risk factor is always there.
What most traders do to maximize gains through arbitrage is that they buy in one market and then simultaneously sell it in another market, quickly profiting from the difference.
Prolonging this action can result in zero profits as the arbitrage opportunity as mentioned earlier is short-term. In other words, the opportunity to earn profits may even be gone in a matter of seconds. How quickly you buy and sell to gain profits from that minor price difference is what can give you an edge, and boost your profit earnings.
Financial education is so important, but barely taught at all in our schools. Having resources online is great, but not if they are inaccessible to so many. Thanks 508!