What Is Arbitrage Trading?

Arbitrage trading refers to taking advantage of a price difference in the same security or asset trading on two separate financial markets to make a profit.

Factors leading to arbitrage opportunities include changes in supply and demand and market inefficiencies. When information can be slow to reach one market, an arbitrageur can take advantage of such discrepancy and take action by trading a security from one market to another.

What Is an Example of Arbitrage Trading?

Say one company’s stock is trading at $10 a share on one exchange, but it’s trading at $10.50 on another exchange. An investor could buy a block of shares at $10 each in that first exchange, and then simultaneously sell that same number of shares on the other exchange at $10.50—pocketing a 50-cent per share difference.

Timing is key with arbitrage, as waiting to sell shares at a later time might lead to the price gap between the shares on the two exchanges narrowing or even closing entirely. This sort of arbitrage strategy can be applied to commodities, bonds, and futures contracts trading on different markets.

What Are the Advantages of Arbitrage Trading?

For investors, seeking disparities in prices can lead to profitability, even in small amounts. Arbitrage can also help to narrow the spread between prices, helping to make markets more efficient. Volatility between two markets or exchanges can provide opportunities to investors seeking to take advantage of up and down swings of prices on securities and assets.

What Are the Disadvantages of Arbitrage Trading?

The use of high-frequency trading and automated trading systems has made arbitrage trading less profitable in the past couple of decades. Computer programs have made it easier for hedge funds and large financial institutions to seek out discrepancies in prices. High-frequency trading has made markets become more efficient by helping to reduce the spread between bids and offers, and this can affect stocks trading on separate exchanges.

For retail investors, the costs of buying and selling stocks in large amounts can reduce the profit of each arbitrage trade. Hedge funds and large financial institutions are better able to handle such transaction costs due to larger volumes of trading.

Are There Other Types of Arbitrage Trading?

When investors seek to take advantage of two companies possibly merging, they look at the share prices of both companies and seek to buy shares at lower prices before the potential transaction becomes known. This process is known as risk arbitrage. In the possibility of an acquisition, investors usually buy shares of the targeted company at lower prices.

In either a merger or an acquisition scenario, investors would sell shares at higher prices to make a profit. This can be risky, however, as the merger or acquisition deal can always fall through.