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Arbitrage is when an investor simultaneously buys and sells an asset in different markets to take advantage of a price difference and make a profit. More likely than not, the price difference is small. But when multiplied by a high volume of trades, it can become substantial enough to allow investors to turn a profit. Hedge funds and other sophisticated investors often leverage arbitrage.
How does arbitrage work?
Arbitrage, at its core, is important for narrowing the price differences between identical or similar assets — typically stocks, commodities and currencies. Arbitrage helps to make the financial markets more efficient by eliminating price differences. Investors can benefit from this by achieving low-risk yields.
Arbitrage typically involves trading a substantial amount of money and requires sophisticated software to identify and act on split-second opportunities. High volumes are required to generate enough profit to cover transaction fees. Therefore, it’s primarily employed by hedge funds and other institutional investors. Individual investors may not have the resources to make it a viable strategy.
Is it illegal?
No. In fact, arbitrage helps eliminate market anomalies, meaning it helps with market efficiency.
What’s an example of arbitrage trading?
Let’s say you’re interested in FakeName Company. Its stock is selling for $300 on a U.S. stock exchange and at 275 GPB on the London Stock Exchange. Assuming an exchange rate of 1 pound to $1.20, the 275 GBP is worth $330. So by buying on the U.S. stock exchange, selling on the London Stock Exchange and converting the proceeds to dollars, you gain $30 per share. Congratulations — you just engaged in arbitrage and made a profit. While this is one of the simplest ways to illustrate arbitrage, not many companies are listed on more than one exchange.
Types of arbitrage
There are a number of different types of arbitrage strategies, including statistical, triangular, cash-and-carry, futures spread and retail. Below we’ll cover two common types: convertible and risk.
Convertible arbitrage: Convertible arbitrage refers to trading convertible bonds, also called convertible notes or convertible debt. A type of fixed income security, convertible bonds work like corporate bonds and pay interest.
An investor using this type of arbitrage takes advantage of the difference between a bond’s conversion price and the current price of the underlying company’s shares. If the bond is undervalued, you’d take a short position on the stock and a long position on the bond. Or, you’d buy the bond and immediately convert it into stock, then sell the stock. Conversely, if you think the bond is overvalued, you could take a long position on the stock and a short position on the bond.
Risk (merger) arbitrage: The most common type of arbitrage currently involves buying stock from a company that’s the subject of a takeover bid and then selling it after the deal closes. This is otherwise known as merger arbitrage because it’s based on the assumption that the merger or acquisition will go through.
How is arbitrage different from speculation?
While arbitrage involves buying the same asset on two different markets to take advantage of the price differential, speculation is a type of investment strategy in which investors bet on the future value of assets. In other words, those who speculate on an asset predict that its value will rise at some point in the future. They buy it today at a lower price in the hope of selling it later for a profit.
However, unlike arbitrageurs, speculators don’t necessarily have a guaranteed return and may even lose their investments if their predictions prove inaccurate. Speculators rely on their own skill and judgment in analyzing an asset and estimating its future value, whereas arbitrageurs do not, as arbitrage strategies are generally systematic and formulaic.
While the idea of arbitrage seems appealing, it’s really only an option for traders or investors who have substantial amounts of capital and high-speed resources. Most opportunities for arbitrage disappear quickly, especially with the current all-digital form of trading.