In simple words, arbitrage trading refers to making profits off differences in prices in different forms or markets. Arbitrage traders would make the most of even the tiniest price differences in two or more markets. A lot of things can fall under arbitrage trading, be it securities, commodities, cryptocurrency, and so on. Let us get into the depths of arbitrage trading.
What does arbitrage trading mean?
The word arbitrage comes from the French word arbitrer, which in turn came from the Latin word arbitrari. No matter which context we see it in, the word must do something with ‘judgment.’ In the modern sense, it is a strictly economic and market term that has a completely different meaning. However, it still retains some elements from the original word which meant judgment or individual decisions. Its strict definition is this: Arbitrage refers to the simultaneous buying and selling of assets to make profits off the differences between their prices.
What is Arbitrage?
When you are buying and selling assets at the same time to make a profit, you are engaging in arbitrage trading. Arbitrage trading exploits the loopholes of the market but also corrects them. The idea is to make a profit, even if it is very small, through the difference in buying and selling prices across different platforms.
Let us take a very simple example to better understand the concept. Let us assume you are interested in sneakers and know which styles are in high demand. Now you see a certain sneaker priced at $500 at one marketplace, and $550 at another. To successfully do arbitrage trading, you would buy the sneaker from marketplace A for $500 and sell it to marketplace B for $550. There you have a $50 profit right in front of you.
Experienced traders do this at a much larger scale and frequency. Arbitrage trading can be done on anything, be it stocks, commodities like gold, silver, or even sneakers, foreign currency, or crypto. It is a viable way of making a living for many people. Once you understand the fundamentals, you can also explore the arbitrage market and how it works.
How Does Arbitrage Work?
Arbitrage works on a combination of errors and meticulous tracking. With improvements in technology, the frequency of errors has gone down. It has led to fewer price mismatches across different platforms. However, arbitrage traders have also produced more sophisticated methods to deal with the crisis. Modern arbitrage traders use complex algorithms to instantly track even the smallest of differences in prices.
However, arbitrage trading needs to have a lot of money invested in the first place to make any meaningful profits. As we saw in the last example, the hypothetical profit was only $50. To make a profit of even $1000, you need some asset that would have such a huge price difference. Alternatively, you can buy and sell in huge quantities. If you earn the $50 profit 500 times, you will end up with a $25,000 profit - which is meaningful considering the time and effort you must put in.
Arbitrage trading works across different mediums and platforms. It can be in the Forex market that deals with differences in the price of a given currency across exchanges. It also works in the crypto market where different exchanges can have tiny errors in price listings. Many entrepreneurs use arbitrage trading in the commodity market without even realizing it. At the same time, commodity arbitrage trading is also done professionally and can be very profitable. Anywhere you see a mismatch of prices, you will also see arbitrage trading.
Who Should Use Arbitrage?
Arbitrage is not recommended for absolute beginners. Once you have some experience in the market, you can get into arbitrage trading. For institutional traders, getting into arbitrage trading is much easier. If you are a retail trader, there are many things you need to take care of. However, with correct guidance and learning, anyone can get into arbitrage trading. It is important to understand that arbitrage trading is risky and requires a lot of capital to start with. Once you are confident about your risk appetite and have access to capital, only then should you get into arbitrage trading.
Types of Arbitrages
There are different types of arbitrages, and they are differentiated on the basis of how you can make a profit and which asset you choose to make a profit. Let us find out more about the different variations of arbitrage.
Retail arbitrage: In the initial sneaker example that we gave, we were talking about retail arbitrage. Retail arbitrage is based on popular goods and items, and not financial assets. Be it a new mobile phone or a new sneaker. It is the easiest type of arbitrage trading to get into.
Simple Arbitrage: If you are buying and selling stock on two exchanges at the same time, you are executing simple arbitrage. It simply means buying the stock at a low price and selling it at a higher price.
Merger Arbitrage: Merger arbitrage is a long-term arbitrage trading strategy where traders target companies that are deemed for a takeover or merge in the future. They buy a company’s stock at a lower price with the expectation that its value would increase after the takeover or merger.
There are other types of arbitrages as well, but they relate to the Forex market. Let us find out more about arbitrage in Forex markets.
Understanding Roles of Arbitrage in Forex
Arbitrage is a popular trading strategy in the Forex and crypto space because of the same reason: their decentralized nature. The Forex market is not centralized like a stock market. It is a global network of different financial institutions and does not have a single governing body. That makes the Forex market conducive to mismatching prices. Different exchanges can have different prices for the same currency at the same time. Forex traders make the most of it by engaging in arbitrage trade.
On top of that, there is continuous fluctuation in the exchange rates because of constant demand and supply dynamics. In such cases, it is very common to have a temporary price mismatch. Owing to increased liquidity in the Forex market, executing arbitrage trades is easier. Arbitrage traders who want to get into Forex arbitrage trading often need to have a margin account first. There are advanced tools and software as well that both retail and institutional traders can use. There is a special type of arbitrage in the Forex market called triangular arbitrage. It is a complex arbitrage trading strategy that is used only in the Forex market.
Triangular Arbitrage
Triangular arbitrage, as the name implies, includes three pairs of currency pairs. It adds a layer of complication that necessitates advanced trading skills. Whenever there are inconsistencies in the Forex market, a triangular arbitrage opportunity may develop itself. Here is an example of triangular arbitrage: A trader would use Currency A to purchase Currency B. The same trader would then purchase Currency C with Currency B. The trader would then finally use Currency C to purchase Currency A. They would potentially make a handsome profit in this process. Because the disparities among exchange rates are very minor, you will need a lot of capital to start with to make even small profits.
Types of Crypto Arbitrage Strategies
There are three main types of arbitrage strategies in the cryptocurrency market. They are called spatial arbitrage, spatial arbitrage without transfer, and triangular arbitrage. When it comes to triangular arbitrage, the strategy is very similar to what it is in the Forex market. A trader would use cryptocurrency A to buy cryptocurrency B and in turn, cryptocurrency C. Spatial arbitrage is like simple arbitrage, where traders buy and then sell the same crypto simultaneously across two different exchanges. While it is a simple strategy, it involves the burden of transfer cost. That is where spatial arbitrage without transfer comes into play.
In spatial arbitrage without transfer, traders try to avoid paying the transfer cost. Traders can use this strategy by going long Bitcoin on exchange A and short Bitcoin on exchange B, then waiting for the pricing of both exchanges to align. This eliminates the need to move coins between exchanges. Trading costs, however, could still accrue.
Arbitrage Opportunities and Risks
Like any other trading opportunity, there are both risks and opportunities in arbitrage trading. When talking about risks, it is important to note that arbitrage requires a big capital, to begin with. As a result, there is always the chance that you would diminish the entire capital without making any profit. There are challenges for retail arbitrage traders as well. For example, institutional traders often create their own tools and algorithms to make the most of price discrepancies. Retail traders do not have this advantage. However, arbitrage is still a great way to make money in the financial markets. It is especially relevant in the Forex market due to its decentralized nature. If you want to get into arbitrage trading, make sure you equip yourself accordingly with the necessary skills, knowledge, and tools.
Conclusion
We hope this guide will help you find your way through arbitrage trading. Remember that you should only get into it after you have considerable market experience. Rushing your way into arbitrage trading can do more harm than good.
Arbitrage Frequently Asked Questions
Is arbitrage trading legal?
Yes, arbitrage trading is completely legal in most countries in the world. In many countries, like the United States, arbitrage is even encouraged as it corrects market faults and inaccuracies.
Is arbitrage difficult?
If you want to make big bucks with arbitrage trading, it can be quite difficult. Beginners should not get into arbitrage trading without proper guidance. If you have considerable experience in the market, arbitrage trading would not be very difficult.
How to make money on arbitrage?
Making money in arbitrage trading depends on two things - the size of the investment and the frequency of the trades. The bigger amount you start with, the more money you make. On the other hand, the more trades you execute, the more money you can potentially earn.
Is arbitrage good for the market?
Yes, arbitrage is good for the market. It prompts exchanges to correct their listing prices and reduce inaccuracies.
How to find arbitrage opportunities?
Institutional traders engage in pure arbitrage through sophisticated software. It is very difficult for retail traders to go into pure arbitrage for this reason. For other types of arbitrage trading, retail traders must keep up with the latest financial news. News of mergers and takeovers is especially important if you want to get into arbitrage trading.
How to know if you have arbitrage?
If you are an arbitrageur, it would reflect on your investment and trading portfolios. You would also have to pay taxes on the earnings as per the law of the land.