Arbitrage definition

What is arbitrage in trading?

Arbitrage in trading is the practice of simultaneously buying and selling an asset to take advantage of a difference in price. The asset will usually be sold in a different market, different form or with a different financial product, depending on how the discrepancy in the price occurs.

Opportunities for arbitrage can occur across almost any asset class, including shares, forex, commodities or derivatives.

With shares, for example, arbitrage can occur when a stock is listed on exchanges in two different countries. Because of discrepancies between the foreign exchange rates in each country, the price of the share can differ between the two exchanges. So, by simultaneously selling the stock on one exchange and buying it on the other, a trader can take advantage of the price discrepancy for immediate profit.

True arbitrage

True arbitrage is arbitrage in its pure form, as detailed above. In essence, true arbitrage takes advantage of inefficiencies in the market, as it involves two assets with an equal fair value trading at different prices. However, the market inefficiencies that make true arbitrage possible have become increasingly rare as technology has improved.

Risk arbitrage

Risk arbitrage involves trading an asset that is currently priced at a value that will soon change: shares in a company subject to a takeover, for example. It is considered a riskier practice than true arbitrage, as the change in asset value may never occur.

Example of arbitrage

Let’s say shares of ABC Incorporated are trading at £37.76 on the London Stock Exchange (LSE) – which is the equivalent of $48.00. ABC Incorporated is also listed on the New York Stock Exchange (NYSE), where shares are trading at $47.85. If you had opened a position to buy the shares on the NYSE and another position to sell the shares on the LSE, at the exact same time, you would have earned a profit of $0.15 per share, or £0.12 per share.

How can traders use arbitrage?

Traders can use an arbitrage strategy with spread bets and CFDs – these derivatives enable positions to be opened and closed quickly. This is a crucial feature of any product used, as the key to the successful use of arbitrage is speed – the faster a trader can react, the better the chance of making a profit.

Some traders choose to use automated trading software, alerts and algorithms to execute their arbitrage strategy. This means they do not have to make their own calculations, as the software will instantly detect arbitrage opportunities.