Arbitrage is the buying and selling of an asset simultaneously to gain profits from the difference in prices of similar assets or securities in different trading platforms.
A simple instance in our daily life can be used to illustrate this scenario. The bullion market can be quoted as a good example. Gold has different prices at different locations. So a trader can buy gold at one location where say 10 gms will cost him Rs 25,000 and sell it at a different location where the price is Rs 25,300. Therefore he stands to gain Rs 3000 risk-free profit. The trader stands to gain only if the profit is more than the costs involved to carry out this transaction (both purchase and sale)
Why is it referred to as an Opportunistic activity?
Arbitrage works due to the imperfections/inefficiencies that exist in the market. It takes advantage of the inefficient pricing of similar financial instruments in similar or different markets. Arbitrage opportunities are often short-lived and will end once the faulty pricing or situation is corrected. Hence it can be referred to as an opportunistic activity.
Types of Opportunities
- Currency Arbitrage – This is a strategy applied in forex trading. This involves taking advantage of variations in currency quotes given by different brokers or banks.
- Uncovered Arbitrage – This arbitrage looks out for changes or fluctuations in the currencies and tries to take advantage of the appreciations in the currency value.
- Time Arbitrage – This arbitrage happens when there is a drop in the stock price of certain securities. When there is selling spree due to a temporary fall in stock price, there are investors who believe in their long-term value, purchase these securities to benefit from it in the long run.
The different types of arbitrage are many depending upon instruments involved or specific situations or reasons that cause imperfections in the market. We also have political arbitrage, fixed income arbitrage and so on.
Likelihood of Arbitrage
This strategy definitely yields a risk-free profit but it is very rare to find such instances. In today’s financial market where everything is highly automated and the instances of errors or inefficiencies are limited, the chances or arbitrage are minimal. Even if exits, it will be rectified almost instantly. A day trader looking to maximize his profits will be able to identify these opportunities immediately but it will also be wiped off in few minutes or seconds.
This strategy is essential to ensure efficient functioning of the financial markets. Any faults or discrepancies in pricing will be noticed and rectified. Thus arbitrage brings about a win-win situation where the trader benefits from the price difference and also leads to market efficiency.