Arbitrage focuses on financially benefitting from price mismatches in the markets. For example, if an asset or even a hot new item does not have the same price in different markets, investors will purchase the cheaper one and then sell it at a higher price to earn an income.
Arbitrage Explained
Arbitrage refers to the act of simultaneously buying and selling the same asset in two separate markets to make the most of the price difference and turn a profit. While the price discrepancies are often small and only last for a short period, the returns can be excellent when multiplied by a considerable volume.
Usually, the price differences in arbitrage include several geographies similar to what is seen in the currency market. They tend to materialize during an information lag.
Keep in mind that arbitrage can be an expensive way to invest, as it typically involves a number of transactions and using a considerable amount of money to receive a significant return. Moreover, arbitrage opportunities are short-lived. They vanish as quickly as they are found.
Types of Arbitrage
Retail Arbitrage
Retail arbitrage is simple to understand and excellently demonstrates the fundamentals of arbitrage. While the buyer takes the risks associated with acquiring inventory and improbability that they may not sell it at their target price, the returns in this strategy can be substantial.
Simple Arbitrage
Simple arbitrage involves the investor buying and selling an asset on different exchanges at the same time. With this technique, investors may consider a significantly low level of risk since the transactions are simultaneously carried out.
Merger Arbitrage
In merger arbitrage, investors take advantage of mergers and acquisitions of two publicly-traded companies. It is an investment approach that carries more risk than simple arbitrage and occurs for a more extended period.
Merger arbitrage involves investors purchasing shares of a public company about to be acquired with the goal of selling the stock once the deal goes through. This arbitrage approach can also involve investors shorting the shares of the targeted company if they believe the deal could collapse.
The price mismatches are not clear right away in merger arbitrage, making it uncertain that investors will generate a risk-free profit. Instead, they are putting their money on the possibility that one could occur.
Merger arbitrage is a long-term proposition, and therefore investors must be prepared to lock up their money for a long time and assume the risk that a merger may not happen or that they would not be able to resell their shares at their desired value.
Arbitrage in the Currency Markets
The currency market can be excellent for arbitrage strategies, considering that all currency trading is done over the counter (OTC) via a broad network of banks and financial institutions. Furthermore, its decentralized nature occasionally leads price differences to appear.
Brief price discrepancies are common in the currency market since currency rates fluctuate continuously based on supply and demand. There is also a huge amount of liquidity in this market, making it easy to execute trades for an arbitrage approach.
However, investors may need highly specialized tools, updated and precise data, and margin accounts to magnify their returns when making the most of arbitrage opportunities in the currency market.
Specific currency exchange calculators can also help investors determine the profit and risk of different arbitrage techniques in this market. They can test free online calculators or opt for advanced calculators offered by brokers and other providers.
