This refers to a profit making activity where buying and selling of a security is done on different exchanges or markets. It can also be defined as the practice of buying an asset and selling it immediately at a higher price on a different exchange.
According to savvy investors, arbitrage is the practice of leveraging market inefficiencies in order to generate profits.
As a potentially lucrative financial strategy, arbitrage is used to create profits that are based on small discrepancies in the market. This allows experienced and fast moving investors to grab the opportunity and make low risk profits.
What you ought to know is that this concept exploits identical or similar financial instruments on different markets.
Types of Arbitrage
a. Triangular Arbitrage
This refers to a discrepancy between three foreign currencies which occurs once the currency’s exchange rate doesn’t have a similar result. It is also a riskless profit which materializes immediately a quoted exchange rate does not equal to the market’s exchange rate.
As a strategy, it exploits the inefficiency of the market where one is overvalued and the other is undervalued. It is common knowledge that price differences amount to a fraction of a cent. In order to make triangular arbitrage profitable, investors have to trade with a large amount of capital.
b. Fixed Income
This is a trade strategy that profits from arbitrage opportunities in interest rate securities. When an investor implements the fixed income arbitrage strategy, he or she assumes opposing positions so as to take advantage of any small price discrepancies.
This is done while limiting interest rate risk. The concept is primarily used by hedge funds and investment firms. This strategy is also used by investors in the swap-spread arbitrage where investors take opposing long and short positions in a swap and Treasury bond.
What you ought to know is that this strategy provides minimal returns and huge losses in some cases.
c. Statistical arbitrage
This refers to a profit situation that arises from pricing inefficiencies occurring between assets. The concept is usually determined through mathematical modeling.
d. Currency Arbitrage
This refers to a foreign exchange strategy where a trader takes advantage of different spreads that are provided by brokers for select currency pairs. It is important to note that different spreads on a currency pair signifies disparities between ask and bid prices.
e. Convertible arbitrage
This is where investors take a long strategy when it comes to convertible securities and short position when it comes to common stock. The strategy is employed to capitalize on price inefficiencies that occur between stock and convertible securities. This strategy is favored by large trading firms and hedge funds.
How Arbitrage works
Let’s assume you have Company A stock trading at $26 on the NYSE. At the same time, the same security is trading at $26.5 on the London Stock Exchange. To capitalize on the difference, the investor or trader will purchase the stock at NYSE for $26 and sell it immediately at the LSE for $26.5.
This means that the trader or investor will earn 50 cents earnings per share. Since the investor’s goal is to capitalize on the market and make profits, the trader or investor may continue to exploit this discrepancy.
This will continue until the NYSE runs out of Company A stock. On other circumstances, the trader may continue with the exploit until prices are adjusted wiping out the advantage.
Final Thoughts
What you ought to know is that arbitrage is an essential trading strategy that enables investors and traders to capitalize on market discrepancies and be able to make profits.
Furthermore, the strategy provides a mechanism that helps to balance discrepancies finally keeping security prices at a fair value.
It is used by small time traders, investment banks and hedge funds. To profit highly, a lot of capital must be used in some cases. The good news is that if traders move rapidly against the market discrepancies, they will profit greatly.