Asset trading has steadily grown to be one of the most profitable ways to make money, and the steady progression of technology is only reinforcing this position the more. The most popular way to profit from the markets is by identifying an undervalued asset, buying it when it is low, then selling it off for a profit when the price has increased. This is mainly done using fundamental and technical analyses, but not in every situation. There are times when traders buy lower and sell higher simply by profiting off of market anomalies. Arbitraging is a prime example of this type of trading.
Now that we know that arbitraging is a form of trading seeking to help traders profit from inefficiencies in the market, how about some specifics? Arbitrage simply works by a trader monitoring asset prices on multiple exchanges. He pays close attention to each price, and looks for potential situations where there are inconsistencies in the asset prices on two or more exchanges. Once he locates such a scenario, he quickly buys the asset on the exchange where it is cheaper, and then sells it on the exchange where the price of the same asset is highest; profiting from the simple inconsistency in the exchanges’ markets. Arbitraging can work in the Forex market, cryptocurrency market, and in fact, any asset class where you can potentially buy and sell in two different markets.
A practical scenario is something that happens almost every day in normal trading of commodities. A trader could go to market in a region where a particular commodity is in high supply (which generally means cheaper prices) to buy a high quantity of the commodity, then go ahead to sell it in another region where the commodity is scarce (generally signaling higher prices for the commodity). An example in the cryptocurrency market is a trader seeing LTC trade for $135.46 on Binance, and $136.02 OKEx. The trader quickly buys 100 LTC on Binance, and sells it on OKEx, making $56 in profits.
There are many types of arbitraging. The most common is spatial arbitraging, as in the above scenarios. In the stock market, another popular type of arbitrating is merger arbitraging, the type that involves longing stocks of a company that wants to acquire another company, while shorting the stocks of the company being acquired. Dual Listed Company arbitrage involves identifying two separate companies in different areas agreeing to function as a single company, but each maintaining its distinct identity. The companies’ stocks tend to move together, but an opportunity for arbitraging is identifying when the stocks of one of the companies is underpriced in its region. The trader buys it, and then shorts the stocks of the twin company overvalued in its region, until their prices align once more.
Triangular arbitraging is one of the most complex of all, as it involves three assets instead of two. A trader buys an asset or currency or commodity (A) with one asset or currency (B), then uses A to buy a third asset or commodity ©, before converting from C back to the initial B. The aim of triangular arbitraging is to find three assets trading against each other with the right price variations, and exploit such. There are several other types of arbitrage like regulatory arbitrage, telecom arbitrage, statistical arbitrage, etc.
Arbitraging is very valuable to both the market and traders. It helps to detect and correct market inefficiencies in the market, while it makes very nice profits for traders. It also does not require very complex technical analysis for the most part, and even a keen financial market amateur could be a successful arbitrageur.
However, arbitraging does possess some risk as well. The price variations in financial markets do not always last for long periods, and the trader risks missing out on the right timing. Moreover, the price inconsistencies are rarely ever large, so arbitraging is much more appealing for bigger investors.
