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What is arbitrage?
Arbitrage is the ability of an investor to exploit a price difference across identical assets in different markets. When the asset sells for more in one market than it does in another market, the investor stands to profit if she buys it in the market where it’s cheaper and sells it in the market where it’s more expensive. Arbitrage doesn’t have great long-term implications as prices usually stabilize quickly.
Arbitrage creates profits based on small discrepancies in the market, giving fast-moving investors the opportunity to make low-risk profits.
Following price info on an exchange, arbitrageurs identify assets that trade at different prices on different markets. Even in very efficient markets where arbitrage opportunities are low, there may be occasions where there’s a disparity due to a sudden change in one market that doesn’t affect other markets at the same time.
As the arbitrageurs trade the assets, other investors may start to take notice and try to follow suit, which increases both supply and demand and causes the markets to rebalance. In this way, arbitrage provides the mechanism to ensure deviations don’t persist for extended lengths of time, which is essential for maintaining fair market value.
Arbitrage is more effective as a trading strategy when the investor knows that the asset she’s trading definitely has a buyer in another market. That’s because arbitrages only exist for relatively short periods of time, so the asset should be traded quickly or the arbitrageur might find that the price has stabilized before she’s had a chance to sell.
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As the sole proprietor of Wayne Pet Stores, Bruce sells bats to exotic animal hobbyists. Bruce buys his bats in bulk at $500 each, and the bats generally go for roughly $1,000 everywhere, earning him $500 in profit per bat. However, Bruce has been following the news and notices that bats are trending in Portland, Oregon, at about $1,250 per bat. He quickly sells as many as he can to hobbyists in Portland and soon the price stabilizes and reflects the national average of $1,000 again. Bruce has turned up a nice profit while locking out others from exploiting the arbitrage and proved to everyone, once again, why he’s known as “the bat man.”