Arbitrage: Definition, Examples, And Strategies

Arbitrage is when a trader buys and sells the same or nearly identical assets at the same time in different locations. When executed successfully, the arbitrager can extract a profit from modest and typically fleeting price differences between those markets.

What’s An Efficient Market?

The idea of arbitrage relies on the theory of efficient markets. The efficient market hypothesis states that markets correctly price in all available information. Investors collectively act as rational economic participants, arriving at the correct price for assets based on all the knowledge that is collectively known at the given time. When new information arrives, efficient markets factor it into the price almost immediately.

Because arbitrage is generally seeking to exploit fractional short-lived pricing discrepancies between markets, it needs markets to behave rationally. If prices acted irrationally for long periods of time, arbitrage, as a strategy, would not be effective. However, in most cases, markets are reasonably efficient and arbitrage pays off for traders with a well-founded strategy.

How Arbitrage Works

Arbitrage traders typically monitor the prices of assets across numerous different markets. When the price of an asset moves a little bit out of sync with its price in other markets, a trader can step in and buy the cheaper version of the financial instrument while simultaneously selling the more expensive version. This locks in a nearly “risk-free” profit if done correctly.

There can be transaction costs, borrowing fees, shipping expenses and so on. But if the price differential is sufficient after these expenses to make a profit, the arbitrager will proceed with the transaction.

How Arbitrage Leads To An Efficient Market

Generally, when traders look at the price of a financial instrument, they assume that it is being efficiently set. That is to say that a stock, bond, commodity, currency, or so on is selling at a fair price. That’s not to be confused with its intrinsic or fundamental value, but rather to say that the price is the same on any major listed exchange. Traders generally trust that exchanges arrive at an efficient price and don’t have to double-check the market before placing orders.

Traders have that confidence precisely because arbitragers are doing their jobs correctly. Let’s look at an example.

Gold can be bought and sold in New York, London, Tokyo, and various other financial capitals. An investment bank can observe the price of gold in all these markets. If the price of gold is trading for $5 per ounce more in New York than in London, for example, an investment bank can short sell gold in New York and purchase it in London. When prices return to being even with each other in both markets, the transaction can be unwound with a $5 per ounce profit for the arbitrager.

Traders can usually buy gold with confidence in either market knowing that there will almost never be a significant price difference between the two exchanges. When even a tiny difference shows up, a sophisticated arbitrager will come along, collect the spread, and force the markets back to parity.

Examples of Historical Arbitrage Opportunities

Gold – Historically, arbitrage has been big in gold and other valuable commodities. In the old days, people would actually have to ship gold around the world to fulfill contracts or engage in other financial transactions. When sudden events such as the outbreak of war happened, the demand for gold could surge in one part of the world, leading to higher prices in that local gold market as opposed to the rest of the world. A savvy trader with connections in overseas markets could take advantage of these temporary pricing discrepancies.

Oil – There are numerous arbitrage strategies around oil and other energy fuels. The price of oil varies greatly by region and quality of fuel. In addition, new sources of supply, such as fracking in the United States, have led to regional gluts of oil. Firms with sophisticated knowledge of the industry and infrastructure to store or transport oil have at times been able to earn fat profits from buying cheap crude in one market and selling more dear energy elsewhere. However, generally, this sort of arbitrage has been limited to specialized players such as integrated oil giants, refining firms, and pipeline operators.

ADRs – Another arbitrage opportunity over the years has been in dual-listed foreign securities with American Depository Receipts (ADRs). A large Canadian bank or telecom company, let’s say, has its primary listing in Toronto on the Toronto Stock Exchange listed in Canadian Dollars. However, to gain access to a wider pool of investors, it also lists shares on the New York Stock Exchange in U.S. Dollars.

Generally, shares are transferrable between Canada and the U.S., meaning these are assets with identical claims on the underlying security. However, the price may be different, particularly if and when the exchange rate between Canadian Dollars and U.S. Dollars is fluctuating. Historically, traders could make a profit by collecting a spread of up to several percent between the values of the two classes of stock. Nowadays, however, computer models can arbitrage these prices very quickly, reducing opportunities to almost nothing in most cases.

Cryptocurrency – A new form of arbitrage has opened over the past decade in the cryptocurrency market. There are dozens if not hundreds of cryptocurrency exchanges around the world. There are vast differences in these exchanges. Some use stablecoins, such as Tether, as their base currency while some are settled in fiat money. Some operate in markets such as South Korea with a different regulatory framework than the U.S. And the levels of credibility and trustworthiness of the crypto exchanges vary greatly.

Mix all these factors together, and one can end up with significantly different prices of Bitcoin and other major cryptos at any given time on various exchanges. Resourceful traders with the ability to manage accounts at several different brokers have been able to arbitrage significant price discrepancies for Bitcoin and other cryptos. There are risks to this sort of strategy, but the rewards can be tremendous, particularly in volatile markets.

Arbitrage Pricing Theory

Arbitrage Pricing Theory, or APT, is a view of portfolio management first put forward by economist Stephen Ross. APT deviates from efficient market theory in that it views some assets as structurally overvalued or undervalued.

APT began as an alternative to the Capital Asset Pricing Model (CAPM). CAPM posits that markets are perfectly efficient, assets are always correctly priced, and thus future returns can be predicted by factors such as risk premiums and beta.

APT, by contrast, does not believe markets are perfectly efficient at all times, and thus investors can generate alpha by owning more of underpriced assets while underweighting exposure to more expensive securities. Over time, as the market corrects toward fair values for both assets, the APT practitioner earns excess returns.

While APT has arbitrage in the name, however, it is not arbitrage in the typical sense of the term as defined in the rest of this article. It is not a risk-free transaction to take advantage of a short-term mispricing of the same asset but rather a directional bet on the relative valuation of various different assets.

Who Are Arbitrageurs?

Generally, arbitrageurs are sophisticated investors with access to large pools of capital. Sophistication is needed to have access to and understanding of how to trade in various markets at the same time. It also generally requires a fair bit of capital to be able to execute simultaneous trades in opposite directions on different exchanges or marketplaces.

It’s common to see investment banks and market makers as arbitragers. Investment banks have access to large amounts of data, capital, and expertise for identifying and exploiting small temporary price dislocations between various markets. Market makers also have a good sense of the trading flow in a given financial asset and may be able to capture small differences in the price of a given stock or derivative asset.

Individual traders can be arbitragers in some cases. However, it generally requires a high level of expertise about the given market that is going to be arbitraged. Generally, it’s not advisable for newer investors to pursue arbitrage as a preferred profit-making strategy, as it is a highly-competitive field with significant barriers to entry.

Can Investors Discover Arbitrage Opportunities In Capital Markets?

On rare occasions, individual investors may be able to find arbitrage opportunities in markets. It often happens in newly forming markets, or ones with limited liquidity. For example, the cryptocurrency market was easier to arbitrage than most others in recent years due to the lack of institutional investors in that marketplace. A few years ago, large investment banks wouldn’t be competing to scalp small differentials in the price of Bitcoin across various cryptocurrency exchanges, making it possible for individual investors to earn a living arbitraging on those exchanges.

Note: Arbitrage is a sophisticated strategy generally carried out by institutional investors. Individuals should use caution before attempting to implement arbitrage-style strategies on their own.

Arguably, for individuals, there are more opportunities to enjoy arbitrage-like opportunities outside of financial markets.

For example, many entrepreneurs and traders have made a living performing a sort of arbitrage in online marketplaces. A savvy individual can buy goods such as textbooks, baseball cards, rare stamps, vinyl records, and the like and then resell them online at a significantly higher price. If a given book is selling for $5 at a garage sale and sells for $25 online, that should be good for a $20 arbitrage minus transaction and shipping costs and the resellers’ time to put the deal together.

Bottom Line

Arbitrage is a sophisticated financial strategy to take advantage of price differentials for an asset between two or more different marketplaces. In general, it is not easy for individual investors to take advantage of arbitrage opportunities. Though, they may come about occasionally, particularly in other walks of life aside from listed financial markets.