What Is Arbitrage? - dummies

What Is Arbitrage?

Day traders work fast, looking to make lots of little profits during a single day. Arbitrage is a trading strategy that looks to make profits from small discrepancies in securities prices.

The word arbitrage itself comes from the French word for judgment; a person who does arbitrage is an arbitrageur, or arb for short. The idea is that the arbitrageur arbitrates among the prices in the market to reach one final level.

In the financial markets, the general assumption is that, at least in the short run, the market price is the right price. Only investors, those patient, long-suffering accounting nerds willing to hold investments for years, will see deviations between the market price and the true worth of an investment. For everyone else, especially day traders, what you see is what you get.

Under the law of one price, the same asset has the same value everywhere. If markets allow for easy trading — and the financial markets certainly do — then any price discrepancies will be short-lived because traders will immediately step in to buy at the low price and sell at the high price.

But what happens if what you see in New York is not what you see in London? What happens if you notice that futures prices are not tracking movements in the underlying asset? How about if you see that the stock of every company in an industry has reacted to a news event except one?

Well, then, you have an opportunity to make money, but you’d better act fast — other people will probably see it, too. What you do is simple: You sell as much of the high-priced asset in the high-priced market as you can, borrowing shares if you need to, and then you immediately turn around and buy the low-priced asset in the low-priced market.

In theory, arbitrage is riskless. It’s illogical for the same asset to trade at different prices, so eventually the two prices must converge. The person who buys at the lower price and sells at the higher one will make money with no risk. The challenge is that everyone is looking for these easy profits, so there may not be many of them out there.

True arbitrage involves buying and selling the same security, and many day traders use arbitrage as their primary investment strategy. They may use high levels of leverage (borrowing) to boost returns. Other traders follow trading strategies involving similar, but not identical, securities. These fall under the category of risk arbitrage.

Good arbitrageurs have a paradoxical mix of patience, to wait for the right opportunity, and impatience, to place the trade the instant the opportunity appears. If you have the fortitude to watch the market, or if you are willing to have software do it for you, you’ll probably find enough good arbitrage opportunities to keep you busy.