With investments and trading, one strategy known is arbitrage which allows traders to lock in gains by concurrently buying and selling identical assets, such as commodities, currencies, securities, and cryptocurrencies across two different markets and exchanges. This technique lets traders capitalize on the price differentials on the same asset across two different markets, known as market inefficiencies.
What is arbitrage?
Arbitrage is a trading strategy that takes advantage of pricing differentials in different markets and exchanges of the same asset. For an arbitrage opportunity to happen, there must be a situation where there are two equivalent assets which have different pricing. Fundamentally, arbitrage is a situation where traders take advantage of the imbalance of asset pricing in different exchanges.
The simplest form of arbitrage trading is buying an asset in an exchange or market where the price is lower and simultaneously selling it in the market where the asset’s price is much higher. It is a widely used investment and trading strategy and considered as one of the oldest strategies that ever existed.
This strategy is closely related to market efficiency theory. According to this theory, for markets to be perfectly efficient, arbitrage opportunities should not be present, meaning all equivalent assets should have the same prices. The convergence of the prices in different markets measures the efficiency of markets.
According to the Capital Asset Pricing Model and Arbitrage Pricing Theory, arbitrage opportunities only occur when there are mispricings of assets. If these opportunities are fully explored and taken advantage of, the prices of these equivalent assets should converge.
How arbitrage trading works
As mentioned, arbitrage trading works due to the inherent market inefficiencies. The supply and demand are the primary driving factors behind financial markets, and a change in either of them can impact the prices of the assets. Arbitrage traders take advantage of these momentary glitches brought about by the inefficiencies.
Traders can use an automated trading system to help them fully enjoy the advantages of the arbitrage trading strategy. These automated trading systems use algorithms to spot pricing gaps, allowing traders to jump on an exploit in the markets before it becomes common knowledge and the markets adjust the pricing.
Types of arbitrage
There are two commonly used types of arbitrage in the markets today: simple or two-currency arbitrage and triangular arbitrage.
Simple arbitrage is the exploitation of the pricing gaps in different exchanges between the same asset. Most often, this happens when two exchanges quote the same asset differently. Using cryptocurrency as an example, let’s look at how simple arbitrage works:
- Exchange A is selling 1 ETH for 0.021 BTC and buying 1 ETH for 0.024 BTC
- Exchange B is selling 1 ETH for 0.024 BTC and buying 1 ETH for 0.028 BTC
In this example, a trader could buy ETH from exchange A, which is selling it for a lower price at 0.021 BTC and immediately sell the ETH to exchange B for 0.028 BTC. If the trader makes this trade with 10 BTC, they could quickly earn a profit of 3 BTC in no time. However, the trader must act fast when they spot such discrepancies, or else if another trader spots this arbitrage opportunity, the market will adjust the pricing, and the opportunity will be lost.
Unlike simple arbitrage that only involves two currencies, triangular arbitrage involves three or more currencies. This type of arbitrage is the result of a discrepancy between the three or more different currencies that occurs when the currency’s exchange rates do not exactly match up.
To better understand this type of arbitrage, we will be using forex as an example. Traders will start with US$1million to trade with the following exchange rate: EUR/USD = 0.8631, EUR/GBP = 1.4600 and USD/GBP = 1.6939.
Using the exchange rate above, a triangular arbitrage works this way:
- Sell USD for EUR: $1 million x 0.8631 = €863,100
- Sell EUR for GBP: €863,100/1.4600 = £591,164.40
- Sell GBP for USD: £591,164.40 x 1.6939 = $1,001,373
- Subtract the initial investment from the final amount: $1,001,373 — $1,000,000 = $1,373
From these transactions, a trader would receive an arbitrage profit of US$1,373, assuming that there will be no taxes or transaction costs.
Arbitrage trading on various assets
Arbitrage trading can be applied to different types of assets. These are the various assets that take advantage of arbitrage:
Commodities are assets that include precious metals, energy, and raw materials that are necessary for our daily lives. Commodities trading is one of the oldest trading markets in the world and is widely used by many people. Arbitrage, on the other hand, is a strategy that involves the simultaneous buying and selling of assets on different exchanges. Commodities arbitrage uses this approach and takes advantage of market mispricing.
Forex arbitrage is the technique of taking advantage of price discrepancies in the forex market. It may be affected in different ways, but whatever manner it was carried out, arbitrage looks to buy and sell currency prices that are currently divergent but too likely to converge rapidly. The expectation is that as the price moves back to the mean, arbitrage trading becomes more profitable and can sometimes be closed even in as short as milliseconds.
Cryptocurrency arbitrage is the concurrent buying and selling of a cryptocurrency to profit from the market inefficiencies. It is a type of trading strategy that profits from the exploitation of the price differences of the same coin on different cryptocurrency exchanges. Cryptocurrency arbitrage can only exist as long as the market is inefficient. Most people who use cryptocurrency arbitrage take advantage of triangular arbitrage.
Arbitrage trading has been around for many years now and has been used as a strategy for various assets. Unlike other investment and trading strategies that capitalize on the value of the assets, arbitrage relies on the inefficiencies present on the markets. This is why arbitrage can still be a profitable asset even if there are economic downturns and global financial uncertainties. Overall, arbitrage is an excellent strategy to use in all market situations.
Image credit: Unsplash