A situation where it becomes possible to make a profit without taking any risk or making any investment.
However, arbitrage opportunities are rare in efficient markets and there a couple strong reasons for that to happen. Whenever an arbitrage opportunity appears in financial markets, investors quickly exploit them because they represent situations where money can be made without taking any risk.
Not only that, but every time investors spot these kind of opportunities, they rush to trade in order to exploit them, leading to an almost instant reaction on prices which eventually ends up mitigating the arbitrage opportunity.
Few important conditions to be violated for arbitrage to occur are:
Same security being traded at the exact same price in the two markets.
The securities must have an identical flow of cash and must be traded at the same equal price.
If the security is bound to change its price in the near future, then it should be sold at a discounted rate now.
Arbitrage is a very broad high frequency trading concept that encompasses wide varieties of strategies to be implemented in the Forex market. It is associated with high risks too. So, it is highly essential for the traders to understand and study the market properly before leaping into this pool.
Arbitrage is a trading strategy which involves the purchase and resale of an asset to exploit short-term price differences between markets in order to make a profit.
Traders who engage in arbitrage are known as “arbitrageurs”.
How does arbitrage work?
Market inefficiencies can mean that the price of an asset occasionally differs between markets. For example, it might be possible to buy an asset for a low price in one market, and then immediately sell it for a slightly higher price in another market. This is sometimes known as “pure” arbitrage.
Another type of arbitrage is “risk” arbitrage which involves a more speculative approach. For example, if it becomes known that the shares of Company A will soon be priced at $15 (after a takeover for example), but those shares are currently trading at $10, a trader could engage in arbitrage by purchasing shares at the lower price and selling them later (once they have reached the expected higher price), in order to make a profit.
Arbitrage is often much more complex than this and can be applied to various financial instruments including currencies, shares and commodities.
Are there any risks involved in arbitrage?
Technically, “pure” arbitrage is said to be risk free, although this is often not the case in practice. There is a chance that part of the transaction could fail, and a sudden price movement may make it impossible to close the trade at a profit.
“Risk” arbitrage involves a greater amount of risk as there is always a possibility that the price of an asset may not move as anticipated.
Learn more about the risk associated with trading and how to properly protect your capital
How easy is it to profit from arbitrage?
It is not easy to profit from arbitrage, especially through exploiting small discrepancies in the markets. Advances in trading technology mean that markets are monitored by automated systems, picking up any arbitrage opportunities which are then quickly exploited and subsequently eliminated.
Due to this, arbitrage is a strategy that may not necessarily suit all traders.