What does arbitrage mean in trading (investing)?
Arbitrage in trading is a specific strategy that can be used when investing. This strategy aims to earn as much money as possible by purchasing a certain object at a very low price and then reselling this product at a higher price. In this way, you keep a sum of money: this is the profit that is achieved with arbitrage. In this blog, we will explain exactly how this works.
Meaning of arbitration
Arbitrage is a key concept in the financial world and it is a specific form of stock trading . It stands for buying shares at a relatively low price and reselling these shares at a significantly higher price on another market.
Shares are usually traded on various markets. To illustrate, a specific share will be used that is centrally located on the AEX in the city of Amsterdam and on the Nasdaq in the bustling New York. This share can have different prices on the two different markets, which is completely normal. Arbitrage plays an important role in this price difference.
Arbitrage in trading
These price differences are picked up by various algorithms. These algorithms ensure that you can buy the share on the stock exchange where it is offered most advantageously. In addition, you can immediately resell the share on the stock exchange where the price is highest. If you sell a number of shares in this way, you can make a lot of turnover and earn a lot of money.
It is logical that you are surprised by the different prices on both markets. This has to do with the efficiency of both exchanges. Arbitrage also plays a role here. Such large price differences are only available for a few seconds, so you need to have a quick reaction time. Arbitrage is often not a strategy that is applicable to the private investor, but mainly for algorithms.
On an exchange that would function optimally, arbitrage trading would not be possible. There would be no price differences for the same share. Arbitrage therefore characterizes a market that is not fully efficient.
If you start trading with the help of arbitrage, you can give the stock market a push in the right direction. If shareholders immediately resell their shares after buying them, the inefficient price differences will quickly disappear.
Arbitrage versus day trading
Day trading and arbitrage have quite a lot in common: both involve price changes and the rapid resale of securities in a short period of time. However, there is a difference between these two things. With day trading, it is wise to do research in advance into the possible future increases of shares. You then take this into account when making decisions. Many shareholders use technical analyses when making choices. With arbitrage, this is not necessary: only the price differences of the share on the two exchanges are important here.
In arbitrage, you observe the share price at a precise moment in time on both markets at the same time. As mentioned earlier, you can make a profit by buying the share for a relatively low price and selling the share on the other exchange for a higher price.
The price is determined objectively at a certain time. No predictions or speculations are made about the future price of the share. A disadvantage is that you sometimes have to pay a slightly different price for the share, because the transactions cannot be executed quickly enough: this simply takes some time. You have to accept this price difference.
Specific Types of Arbitrage in Trading
There are many types of arbitrage, but this article will only cover the types that occur in trading.
Arbitrage on various exchanges
In addition to buying and selling shares with price differences, there are other ways to make a profit. There is also the possibility of arbitrage on other markets, such as the currency market, where you can play on the price differences in the data of brokers or banks.
To illustrate, let’s take the following example: there are two banks that have set two different prices for EUR/USD:
- Bank A offers one euro for $1.16 and sells it for $1.17
- Bank B offers one euro for $1.18 and sells it for $1.19. In this case, you can buy several euros from bank A (for $1.17) and then sell these euros to bank B for $1.18. In this way, you can profit from price differences on the currency market. In the past, however, this was somewhat smoother. Now, banks have a much better overview of all prices. In addition, the currency market has become much larger, which makes the use of arbitrage more difficult.
Interchangeable Arbitration
Convertible or exchangeable arbitrage is a type of arbitrage in which one tries to make a profit with as little risk as possible. The shareholder has a convertible bond and the shareholder is also in a short position with respect to all the shares of that company. The risk is considerably lower here, because these convertible bonds are less affected by price fluctuations compared to the other shares of a company.
A convertible bond is a fixed-rate debt from a particular company that brings in money. This type of bond is different from others because this bond can be converted into a specific set of shares. The conversion of the bond into shares can be done at various times during the life of a bond. The business owner is in charge of this.
If the price of a stock falls, a shareholder may be lucky enough to exploit the short position to the fullest, while the convertible bond normally has less risk. In the best case, a fall in prices should mean a profit on the short position and only a very small loss on the convertible bond.
On the other hand, if prices rise, the loss on the short position should be minimal, as the gain on the convertible bonds can compensate for this. Even if you trade the stock sideways, this may mean that the convertible bond is not connected to paying interest, as the short position compensates for this. In any case, you do not lose money and you do not incur any costs.
This technique is almost never seen. The modern technology and all the innovations have resulted in these specific deviations being quite rare on the stock exchange.
Arbitration in triangular form
A triangular arbitrage is very similar to normal arbitrage that we have discussed earlier. In this form of arbitrage, the shareholder sells three currency pairs at various banks or brokers. With the aim of making a profit in the long term by being creative with the prices.
This only works with different banks, because you can’t hand in and exchange all currencies at the same bank. Banks and brokers are smart enough to use a functional pricing system. This prevents customers from milking these price differences in order to profit from all the fluctuations.
Here’s an example to make it clear. If you want to exchange euros for US dollars at bank A, you can then convert these dollars into British pounds at bank B. Finally, you can convert these pounds back into euros at bank C. If everything goes smoothly, you will have more euros in the final phase than at the beginning.
This is certainly not simple and involves various risks. The price differences are also quite small. The use of triangular arbitrage is therefore discouraged and is only reserved for experienced investors who have a lot to spend.
Is there a way to make a profit with the least possible risk?
If you buy a certain share and sell it again, you make a profit and stimulate the economy. If you plan to do this with shares, you must be aware of the risk because you cannot predict the future. The share can suddenly fall and then you can make a loss. That is why investing in shares is certainly a risky sport.
But you can also buy a share where you are assured of a higher price than the purchase price. The risk is then gone. Because with arbitrage you make profits through holes in the market and in the system, you are (to a certain extent) certain of profit. In addition, the profit is also legitimate, because these are official stock exchanges and prices.
In many cases, it is difficult for private individuals to quickly observe the price differences on the stock exchanges. Arbitrage is often accompanied by algorithms and various programs that signal the price differences on the stock exchanges and respond to them in a clever way. These are useful tools because the price differences occur in a short time (think of (milli)seconds). Most private investors do not have these types of systems at their disposal, and this makes it a very difficult activity for many people to perform. If you do notice the price differences in time, you can make your move. However, you will probably make little profit due to transaction costs and other costs. In addition, the exchange rates are sometimes also problematic. Some stock exchanges use different currencies and it is possible that the final rate is much higher than you initially expected. You have to take many factors into account in order to ultimately keep a nice amount of money.
Traditional Exchanges vs. Cryptocurrency Markets
On traditional exchanges, it is almost impossible to use arbitrage. And if it does exist, it is only possible for computers that automatically buy and sell at a certain price.
In crypto markets, there are opportunities for arbitrage, because there are various platforms where you can go as a consumer. On these platforms, different prices are used for certain coins. You can therefore make good use of this by playing on the different prices that are offered.
Prices on South Korean platforms are often much higher than prices on European or American platforms. Factors that influence this are the size of the market and the volume of the platform. As the market becomes larger and as the volume increases, you can use arbitrage less. You should keep this in mind.
