Understanding Arbitrage Trading From a Beginner’s Perspective
Synopsis: As more novice traders attempt to figure out the forex industry for themselves, it’s important that they have all the necessary information on the strategies available. Arbitrage trading is a strategy that can offer great returns, provided it is studied and understood well enough.
What Is Arbitrage Trading?
Experts define arbitrage trading, in forex, as an opportunity for traders to, “lock in gains by simultaneously purchasing and selling an identical security, commodity, or currency, across two different markets.”
An Alpha Roc report defines arbitrage trading as, “a trading strategy that takes advantage of pricing differentials in different markets and exchanges of the same asset.”
For an arbitrage opportunity to happen, the Alpha Roc report continues, there has to be a situation where there are two equivalent assets that have different pricing.
From a fundamental perspective, 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, at the same time, 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.
For beginner traders and other parties who are new to the field of trading, it’s important to understand the concept of arbitrage and what it is, before launching into this strategy.
Real-Life Examples of Arbitrage in Practice
- Exchange Rates
Exchange rates are a key and prevalent form of arbitrage trading. For example, if the exchange rate in Europe is €1 = $1.85 while the exchange rate in the US is €1=$2.25, a savvy consumer can make a profit simply by converting their money from dollars to Euros in Europe, then converting it back when they return to the U.S. Arbitrage can be as simple, or straightforward, like that.
2. Sports Betting
The sports scene is another area where you can find examples of arbitrage — they also refer to it as “arbing”. Different bookmakers present different odds on various events, so this gives gamblers a chance to bet on different amounts on all possible outcomes of one, or multiple, events. This methodology guarantees a profit no matter what happens as a result. An extreme case of this could be the following scenario:
If bookmaker A offers odds of 5-to-1 that the Rockets will win, and bookmaker B raises the stakes and offers offs of 60-to-1 that the same team will lose, a gambler can choose to bet $10 with the first and $5 with the second, knowing that no matter what happens, they will receive a return.
3. Corporate Offshoring Tactics
Arbitrage also occurs on a corporate scale. Global labor arbitrage, commonly called “offshoring,” refers to a form of arbitrage in which companies move their assets to countries with the lowest labor costs, paying less money for the same work.
4. Cryptocurrency Trading
Many investors in the cryptocurrency space practice arbitrage. Cryptocurrency value is highly variable, fluctuating often, and dependent on a variety of factors. By focusing keenly and keeping a close eye on those factors, such as investor interest, media response, the levels of supply and demand, savvy crypto investors can spend a small amount of money buying into a given cryptocurrency, then selling it for conventional currency when the value is at its highest.
5. Internet Marketing
The concept of arbitrage is a very important part of Internet marketing, with a particular focus on affiliate marketing. An affiliate marketer — defined as someone who is paid a commission for promoting a company’s product online and delivering sales or engaged leads — can purchase low-cost traffic to earn a significantly higher commission.
Understanding how arbitrage works in the real world makes it easier to understand how one can approach it in an actual trading scenario.
How arbitrage trading works
As mentioned, arbitrage trading works due to and thrives off of the inefficiencies within the market. Alpha Roc further elaborates that the supply and demand, of a given asset, are the primary driving factors behind financial markets, and a change in either of them can impact the prices of the assets.
It is an arbitrage trader’s job to take advantage of these momentary glitches brought about by the inefficiencies in order to make a profit.
This, however, does not need to be done manually. Traders can make use of an automated trading system to help them benefit from the full advantages of an arbitrage trading strategy.
These automated trading systems utilize 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.
The Bottom Line
Although it’s popularity is a relatively recent development, arbitrage trading actually isn’t a new trading strategy. It has actually been around for many years now and has been used as a defining 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.
Experts share varying opinions on the efficacy of arbitrage trading and the fact that it hinges on what are seen as “glitches” in the system, but these are just semantics.
Through the years arbitrage has been and can still be a profitable asset even if there are economic downturns and global financial uncertainties.
If the appropriate amount of due diligence is practiced (studying, analysis, and consulting experienced experts in arbitrage trading), this can be an excellent strategy to use in all market situations.
