Arbitrage Definition: An Explanation of Arbitrage Trading

Arbitrage is the act of buying and selling the same security in different markets at the same time. Price discrepancy creates opportunities for investors to make a low-risk profit. These short-term price differences exist due to financial market inefficiencies; however, today automated trading platforms resolve pricing variations much faster, reducing arbitrage opportunities for most traders.

Different types of arbitrage strategies buy and sell various financial instruments, including stocks, currencies, commodities, and derivatives. Types of arbitrage trading include:

1. 1. Cross-border arbitrage: This form of arbitrage often occurs when the same security trades at different prices in varying countries. Since cross-border arbitrage is an international trading strategy, large companies typically use this approach more than the average investor.
2. 2. Merger arbitrage: When a company acquires another business, there is always the risk the deal might fall through. Thus, the share price of the target company usually does not reflect the deal price. Merger arbitrage takes advantage of this notion, as traders purchase shares of the target company at a slight discount.
   
3. 3. Retail arbitrage: Buying discounted products and reselling them at a higher price site is another form of arbitrage. You can practice retail arbitrage in person or online through different selling platforms.
4. 4. Spatial arbitrage: Identifying price discrepancies in the same securities within the same market across different geographic locations is spatial arbitrage. If gold is currently selling at a lower rate in London versus India, traders can purchase gold in London and resell it at a higher price in India to maximize on this disparity.
5. 5. Triangular arbitrage: Differences in foreign exchange rates result in opportunities for triangular arbitrage. When there is a price discrepancy of a currency in three different countries, traders can convert a sum of money into each currency to eventually generate a profit. For instance, converting US dollars into Thai baht, Thai baht into Vietnamese dong, and Vietnamese dong back into US dollars is triangular arbitrage.

Consider this example of arbitrage in the stock market. When a company’s shares have a market price of $10 on the New York Stock Exchange and $10.10 on the Tokyo Stock Exchange, there is an arbitrage opportunity. Traders can purchase shares on the New York Stock Exchange to immediately resell on the Tokyo Stock Exchange at a higher price. The slight price variation provides investors with a profit of 10 cents per share.

More complicated examples of arbitrage trading involve mergers and acquisitions. Hedge funds often use mergers as an arbitrage investment strategy. Fund managers analyze expected acquisitions to determine whether the merger has solid potential for profit.

When a company acquires a target company, the share price of the target company increases to that of the purchasing company. Before the merger takes place, investors can purchase stock of the target company to eventually resell them at a higher price after the acquisition takes place.

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