How Does Arbitrage Work in Investing? Explication And Examples

Entrepreneurs and investors are always looking for ways to make money. Whether through investing in the stock market, commodities, or real estate. One of the most effective strategies is arbitrage trading. This involves taking advantage of an opportunity that arises from being able to execute a trade with two different brokers at different prices.

The market is constantly moving, and prices often change rapidly. Investors who can spot opportunities to purchase an asset at one price and sell it at another price have the potential to earn a significant profit in a short time.

How Does Arbitrage Work in Investing Explication And Examples

Investors can use several different types of arbitrage strategies when trading assets. This article will explore how arbitrage works in investing and provide examples of this strategy.

1. Use of Tactical Asset Allocation

Arbitrage is also often used as a part of tactical asset allocation. It involves taking advantage of price gaps between different types of assets, such as stocks and bonds. This tactical arbitrage helps make more money in asset tie-up investments. This is because, in tactical asset allocation, investors use arbitrage to produce short-term trades to profit from changes in the price of different assets.

For example, an investor might notice a stock trading for $100 on one exchange but only $98 on another. By buying shares of the stock at a lower price and selling them for a higher price, they can earn a profit of $2 per share. To execute this type of arbitrage, investors often use automated trading or algorithmic trading platforms that can quickly identify and execute profitable trades based on changes in asset prices.

2. Market Arbitrage

Another common type of arbitrage is market arbitrage, which involves taking advantage of market price differences. For example, suppose an asset trades for $100 on one exchange and only $99 on another. An investor might purchase the asset at a lower price and sell it at a higher price to earn a profit of $1 per share.

This type of arbitrage is typically performed by large investment funds or individual investors with access to sophisticated trading strategies that can be used to buy and sell assets on multiple exchanges quickly. These investors can often profit from small price differences in a short period by utilizing market arbitrage.

3. Arbitrage for Hedging

Arbitrage can also be used as part of a hedging strategy. This involves taking advantage of price differences between the same asset on different exchanges to protect against changes in market conditions. For instance, if an investor owns shares in Company A that are trading at $100 but they also own shares in Company B that are trading at $105, they might use arbitrage to hedge against a potential drop in the price of Company A.

Hedging can be an effective way for investors to balance their portfolios and protect themselves from losses in case of market volatility or other events outside their control. By utilizing arbitrage as part of their hedging strategies, investors can help reduce the risk associated with investing.

Arbitrage Strategies

4. Zero-Sum Arbitrage

In addition to the other types of arbitrage mentioned above, there is also a type known as zero-sum arbitrage. This involves taking advantage of price differences between two assets moving in opposite directions. For example, suppose an asset is trading for $100 on one exchange and $102 on another.

Investors who can successfully implement zero-sum arbitrage can earn a profit of $2 per share. This type of arbitrage is often used by short-term traders and hedge funds, as it requires the ability to analyze complex market data and identify profitable trading opportunities quickly. However, with careful research and planning, individual investors may also utilize this type of arbitrage to generate additional income from their portfolios.

5. Arbitrage Between Futures and Cash Markets

Finally, investors can utilize arbitrage to profit from price differences between futures and cash markets. For example, suppose that an asset is currently trading for $100 on the current market but has a future contract that expires in 6 months at $102. An investor might purchase shares of the asset at the current market price and sell them for a profit six months later once the future contract expires.

This type of arbitrage can be attractive to investors looking to generate additional income from their portfolios in a low-interest rate environment or during periods of high market volatility. However, it is vital to have a solid understanding of the mechanics and risks associated with futures trading to execute this type of arbitrage successfully.

6. Use of Options to Arbitrage Volatility

Arbitrage can also take advantage of price differences between options on the same asset, particularly for investors who trade in options markets. For example, suppose that an investor owns a call option with a strike price of $100 and a put option with a strike price of $95. If the current market price of the underlying asset is $102, the options may have different implied volatilities.

The investor can use this price difference to profit by creating a synthetic long position with the call and a short position with the put. This is known as volatility arbitrage and can be an effective way for traders to generate additional income from their portfolios during periods of high market volatility or other market conditions.

7. Arbitrage Between ETFs and Their Underlying Holdings

Finally, some investors use arbitrage to take advantage of the differences between ETFs and their underlying holdings. For example, an investor might purchase shares in an ETF that tracks a specific index, then sell short-term calls on the underlying stocks in this index. If the prices of the individual stocks rise faster than the price of the ETF, they can profit from this strategy.

Arbitrage between ETFs and their underlying holdings is a relatively new arbitrage strategy that has become popular in recent years. One key benefit of this strategy is that it allows investors to earn profits even when the prices of the assets in an index are relatively stable. However, there are also some risks associated with this strategy, including the potential for losses if the prices of individual assets move in unexpected directions.

Arbitrage is a powerful investment strategy that can generate short-term profits by taking advantage of the differences in prices between different markets and assets. As shown above, there are many different types of arbitrage strategies, each with its own risks and benefits. Whether you are an experienced investor or just starting, it is crucial to carefully evaluate all arbitrage opportunities before making investment decisions.

Dragan Sutevski

Posted by Dragan Sutevski

Dragan Sutevski is a founder and CEO of Sutevski Consulting, creating business excellence through innovative thinking. Get more from Dragan on Twitter. Contact Dragan