Arbitrage is the practice of buying and selling an asset simultaneously in order to capitalise on price differences, either on different markets or in different forms of that asset. Profits are made in the price difference between those two markets, or in the increased value of an asset in one form over another. Arbitrage involves almost no negative cashflow due to the rapid nature of trading, offering the opportunity of risk-free profit after transaction costs.
Because arbitrage relies on market inefficiencies, its practice can help ensure prices don’t deviate too substantially from their fair value for lengthy periods of time. For this reason, arbitrage isn’t usually a long term strategy, and new opportunities often have to be found after taking advantage for a short period of time. It is also becoming more and more rare, particularly for the common investor: with advancement in trading technology, many firms’ trading systems can track fluctuations in similar instruments across markets and act upon them quickly. This then eliminates the opportunity for arbitrage.
A traditional example of arbitrage would be if a trader were to source wheat in an agricultural region, where it is easily obtainable and therefore cheaper (supply outweighs demand), but he also knows a buyer in an urban area where the market price is higher. He would then buy from the farmer while setting a contract to sell to his buyer at the higher price, exploiting the difference in market prices for the commodity. This, however, discounts the time required to do so and possible travel expenses and storage costs, which make it much more difficult to make a profit on such transactions.
Another example of arbitrage in practice – though again, unlikely due to market efficiency and high-frequency trading – would be if a stock trades at $3.50 on the NYSE and $3.53 on the LSE, the arbitrager could simultaneously buy from the NYSE and sell on the LSE to gain a small but risk-free profit. The trader must have sufficient scale and a large enough order to be able to keep transaction costs low and make a profit after commission. Their trade would of course quickly address the disparity in exchange prices, removing the arbitrage opportunity but the agent will keep arbitraging until the break even point. Arbitrage opportunities are almost always fleeting, and must be capitalised upon quickly.
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