Definition:
Arbitrage is a trading strategy that involves simultaneously buying and selling an asset in different markets to profit from price discrepancies. It’s a risk-free strategy that aims to capture profits without taking on additional risk.
Key characteristics of arbitrage:
- Risk-free: Arbitrage opportunities are generally considered risk-free as they involve buying and selling the same asset at different prices, ensuring a profit regardless of market fluctuations.
- Efficiency: Arbitrage helps to maintain market efficiency by ensuring that prices are aligned across different markets.
- Short-term profits: Arbitrage opportunities are typically short-term and focus on capturing small profits.
- Competition: Due to the potential for high profits, arbitrage opportunities are often quickly identified and exploited by traders, limiting their availability.
Example:
If a stock is trading at $50 per share on one exchange and $55 per share on another exchange, an arbitrageur could buy the stock on the cheaper exchange and sell it on the more expensive exchange, capturing a profit of $5 per share.
Why is arbitrage important?
- Market efficiency: Arbitrage helps to ensure that markets are efficient by eliminating price discrepancies.
- Profit opportunities: While arbitrage opportunities are often short-lived, they can provide a source of profit for traders.
It’s important to note that while arbitrage can be a profitable strategy, it requires quick execution and access to multiple markets. Additionally, market frictions such as transaction costs and price delays can limit arbitrage opportunities.
