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Arbitrage trading strategies can help a stock trader to gain more profit during the period of price discrepancies in various markets. For example, you are buying an asset from the US market and selling it to other markets when the price for that asset shows discrepancies. By doing this we will gain profit for the same asset.
What is Arbitrage Trading | Arbitrage definition?
Arbitrage trading is a strategy to gain profit in the situation of simultaneously buying and selling an asset having price differences, across different exchanges or markets. In Arbitrage trading Shares, Commodities, and Currencies can be traded. But along with this, there are some disadvantages to this strategy.
Example of Arbitrage trading
Let us assume the price for Crude oil in the New York Stock Exchange (NYSE) is lower as compared to European New Exchange Technology (EURONEXT). Then, if you buy crude oil from the York Stock Exchange (NYSE) at a lower price and sell it to the European New Exchange Technology (EURONEXT) to gain profit.
Hence, for taking advantage of these tiny price differences for crude oil between the two different exchanges, here, we are using the Arbitrage trading strategy.
Let’s learn through a Mathematical Example
Consider, there is a company, let’s say company A. The price of 1 share of company A is trading at $25 on the New York Stock Exchange (NYSE). At the same time, the price of 1 share of company A is trading at $25.05 on the European New Exchange Technology (EURONEXT).
Now the trader can buy shares of company A from the New York Stock Exchange (NYSE) and sell them immediately on European New Exchange Technology (EURONEXT). Here, by the use of the Arbitrage technique, the trader can earn a profit of 5 cents per share.
Things to remember before entering an Arbitrage trading setup
There are a few things or if say requirements that are required before creating an Arbitrage trading setup. From the point of view of a stock trader, these things matter a lot.
- Requirement of good information about the market situation.
- Low or Zero transaction costs (Explicit costs).
- Low or Zero transaction costs (Implicit costs).
- Instantaneously buying and selling, also requires very fast speed.
Types of Arbitrage Trading
There are lots of types of Arbitrage trading, such as Pure Arbitrage, Retail Arbitrage, Merger Arbitrage, Convertible Arbitrage, and so on. In words it is,
- Gold Arbitrage.
- Currency Arbitrage.
- Credit Card Arbitrage.
- Arbitrage in Cryptocurrency, and so on.
Advantages of Arbitrage Trading
- In Arbitrage trading, a trader can make a riskless profit, which means, it has low risks.
- It makes financial markets more efficient and adds liquidity to the market.
- You can also invest in Arbitrage funds, which are less risky and have many other benefits.
- It helps markets by controlling the price variances in securities.
Disadvantages of Arbitrage Trading
- The profit is small, as returns are limited, with a limited risk strategy.
- It requires perfect market information along with advanced software and algorithms.
- There is an execution risk in Arbitrage trading in terms of execution of 2/3 trades at the same time, etc. Also in Arbitrage trading, we have to face different trading timings for different exchanges.
- Transaction costs (Explicit costs and implicit costs).
- It requires a lot of money, that why, arbitrage trading is mostly engaged by hedge funds and institutional investors.
FAQ – Arbitrage Trading
Is Arbitrage Trading Legal in the US?
Yes, Arbitrage trading is completely legal in the United States of America. In the US, as well as in other financially strong countries, Arbitrage trading is considered good practice for conducive overall market efficiency.
Is Arbitrage Trading Strategy always profitable?
No, as Arbitrage trading is a simultaneous buying and selling of an asset in different markets for taking advantage of price differences. Hence, you may also face loss instead of profit. Getting profit in Arbitrage trading depends on multiple factors, such as price discrepancies, timing, execution, information, software performance, the number of instruments, etc.
On another hand, there is no such strategy in the market that always gives a profit. If it is so, then, why there are so many losses in the market along with profits? But yes the same strategy can be different in accuracy for individuals. The same technique can be 70% accurate for one person, can have 30% for another person, and so on.