Arbitration is a specialized investment technique that involves the simultaneous purchase and sale of a security in different markets to profit from temporary price disparities.
In our digital world of instant communication, markets are highly efficient. Price differences in the same security on different markets or exchanges are rare, and when they occur, they don’t last long. For this reason, arbitrage is a sophisticated investment strategy usually only attempted by professionals.
Arbitrage opportunities are hard to find and usually vanish quickly, but for those who know how to spot them, they can be highly profitable.
The key to successful arbitration is being able to identify and take advantage of inefficiencies that exist between different markets. These inefficiencies can show up as small but significant price differences that can be exploited by knowledgeable traders.
Arbitrage traders are always on the lookout for potential transactions. When they spot a price difference or what they feel is a profitable inconsistency in a large, liquid market, they move fast. Once a favorable situation is recognized, traders quickly engineer a large-volume trade that, depending on the type of arbitrage they are using, might involve buying a security on one market and, at the same time, selling it on another at a higher price . They use the proceeds of the sale to pay for the purchase, and they bank the profit.
Arbitration is considered an alternative investment strategy that requires a high level of expertise. There are several arbitration methods. Below are the most popular kinds of arbitrage used by investment professionals on Wall Street and around the globe:
- Pure arbitration† The most straightforward type of arbitrage is called pure arbitrage. This strategy consists of identifying a price differential on a certain security on different exchanges and, at precisely the same moment, buying it at one price and selling it at another higher price for a low-risk profit.
- Cash and carry arbitrage† This sophisticated form of arbitrage uses futures contracts to lock in gains. When the price of a security is higher in the future – which is to say, on the futures market – traders will buy the security on the spot market and sell the corresponding futures contract for a tidy profit.
- Merger arbitration. Mergers often involve one public company buying the stock of another public company for a specified price. While details are being worked out but before a deal closes, shares of the target company often trade for somewhat less than the buyout price. Merger arbitrage is conducted by buying shares of the target company at a discount to the buyout price and making a profit when the deal becomes final.
- Convertible arbitration† Convertible bonds are a type of debt security that can be converted into stock based on a predetermined formula. A comprehensive analysis of prices and conversion ratios will sometimes reveal an arbitrage opportunity. Traders will, depending on circumstances, either buy or sell the stock while doing the opposite with the convertible bond to earn a capital gain.
Most investors will never participate in arbitrage, but it never hurts to be knowledgeable about alternative investments. Understanding arbitration can help you understand the workings of the overall financial markets.
- Huge profit potential. Even a tiny price difference can yield massive returns if trades are done in large volumes.
- risk mitigation. By setting up trades to be simultaneous and contingent upon each other, meaning they only happen if a profit is assured, risk is kept to a minimum.
- Small opportunity window. Arbitration opportunities develop and disappear quickly. To make money, traders must act very quickly.
- complexity. In most cases, discovering and executing profitable arbitrage trades takes comprehensive, specialized knowledge.