Everything You Need to Know about Arbitrage Trading

What is Arbitrage Trading?

Arbitrage, a Definition

Arbitrage is a technique traders use to profit from price differences between two or more markets. It involves buying an asset on a market where it is undervalued and simultaneously selling it on another market where it is overvalued, in order to make a profit from the price difference.

Arbitrage generally occurs when markets are inefficient. Market inefficiency is when asset prices do not reflect their fundamental value and information available on the asset.

Arbitrage can be used virtually everywhere: the equity market, the bond market, the FOREX market, and the cryptocurrency market. You can also use different financial products in arbitrage trading, such as futures, options, and CFDs.

Arbitrage and the Efficient Market Hypothesis

According to American economist Eugene Fama, a market is considered “efficient” or “perfect” when the price of financial assets always reflects all available, relevant information.

The efficient market hypothesis assumes that investors and traders are rational and process information objectively.

This would make it impossible to beat the market.

Since arbitrage is a trading strategy that exploits market inefficiencies, many advocates believe it contradicts the efficient market hypothesis.

Others, in contrast, believe that the use of arbitrage by traders enhances market efficiency.

Wait, what? This seems contradictory.

The fact is arbitrage enhances market efficiency simply by correcting price anomalies and increasing market liquidity.

It is also worth pointing out that the efficient market hypothesis doesn’t say that prices are always right. It assumes that they reflect all the information available at a given time. 

In this case, arbitrage can help to reduce price differentials by converging prices towards their fundamental or average value.

What are the Different Forms of Arbitrage Trading?

Pure arbitrage

Pure or true arbitrage is arbitrage in its most classic form.

This is buying and selling the same asset on two different markets to take advantage of a price difference between the two markets or two financial intermediaries.

For example, a stock can be listed in the United States and Europe, and its value can differ even when the exchange rate is factored in.

In such a situation, you can buy the stock on the market where it is the least expensive and sell it on the market where it is worth more.

You can see the differences in currency or cryptocurrency prices between two brokers or exchange platforms.

The principle is the same: buy the least expensive and simultaneously sell the most expensive.

You can also use this approach with two non-identical but similar (or correlated) assets, such as two stocks in the same industry.

Arbitrage on mergers and acquisitions

Specific to the equity market, this type of arbitrage involves taking advantage of the market dysfunction surrounding mergers and acquisitions.

In a merger, the acquiring company must acquire the outstanding shares of the target company. This usually involves paying a premium on the market price of the target company’s shares at the time of the announcement. As a result, shareholders of the target company generally see their share price rise.

However, the target company’s share price rarely corresponds to the transaction price and often trades at a slight discount due to the risk that the deal might fail.

M&A arbitrage involves buying shares in the target company at a discounted price, then profiting from it when the deal is completed. 

Other forms of M&A arbitrage may involve short-selling the target company’s shares if the investor believes the deal may not go through.

Traders using this type of arbitrage trading focus on assessing the probability of the M&A deal being approved and how long it will take to complete.

Convertible bond arbitrage

Convertible bond arbitrage is designed to take advantage of market inefficiencies related to the relationship between the convertible bond’s price and the underlying stock’s price.

A convertible bond gives the holder the right to convert it into shares of the underlying company at a later date, and often at a reduced price. 

Traders using convertible bond arbitrage seek to profit from the difference between the conversion price of the bond and the current price of the company’s shares. 

To do this, you must simultaneously open a long position in the convertible bond and a short position in the underlying shares.

Volatility arbitrage

Option prices will be affected if the underlying asset’s expected vs. implied level of volatility differs. This can result in a difference between the option’s expected price and its actual market value.

Profiting from this difference is part of a volatility arbitrage strategy.

Volatility arbitrage, therefore, aims to take advantage of the spread between the expected future volatility of an asset’s price, such as a stock, and the implied volatility of the options related to the asset.

Triangular arbitrage

When the exchange rate of two currencies is equal to that of a third currency, the exchange rates of all three currencies would have to match to eliminate any opportunity for profit. 

On the other hand, if the exchange rates are not all the same, there may be an opportunity for profit.

Although rare, triangular arbitrage occurs when there’s a discrepancy between the exchange rates of three currencies, allowing traders to take advantage of the price differentials.

All you have to do is find one currency that is overvalued against another currency and simultaneously undervalued against a third currency.

Currency carry trade

The carry trade strategy is arbitrage that profits from interest rate differentials on the foreign exchange market.

You borrow one currency at a low interest rate and invest in another currency yielding a higher interest rate.

This strategy aims to profit from the interest rate differential without considering shifts in exchange rates.

The interest rate differential between these two economies is considered a price differential that can be leveraged for a profit.

Examples of Arbitrage

Let’s assume that XYZ company’s shares are listed at EUR 35.70 on the Paris Stock Exchange. 

The company is also listed on the New York Stock Exchange in USD at 40.03 per share.

One share of XYZ company listed on the Paris Stock Exchange would be worth USD 39.83 with a EUR/USD exchange rate of 1.11575.

If you have a sell position on the New York Stock Exchange and a buy position on the Paris Stock Exchange simultaneously, you can make a profit.

Your profit would be USD 0.20 or EUR 0.17925 per share, factoring in the price differential between shares listed in Europe and the United States.

Here is another example of “general” arbitrage involving two similar but different assets.

Suppose you think Pepsi shares are undervalued and Coca-Cola shares are overvalued.

In this case, you will open a long position on Pepsi (buy) and a short position on Coca-Cola (sell or short sell) to take advantage of this difference.

Advantages and Limitations of Stock Market Arbitrage

Why use arbitrage trading?

Here are the advantages of using arbitrage trading:

• Take advantage of price spreads to make a profit and maximize earnings.

• Reduce market risk by using pure arbitrage on identical assets in short-term transactions.
• Use different forms of arbitrage depending on the opportunities.

• Trade with as much leverage as possible to increase your earning potential and benefit from better execution.

• Use automated trading strategies to quickly and methodically profit from market inefficiencies.

What are the disadvantages of arbitrage?

Although the arbitrage technique is considered low risk, any trading activity involves risk and has its limits:

• You must have significant capital to take advantage of arbitrage trading since you are working with minimal price differentials.

• If you use leverage in the stock market, losses can be substantial.

• You must be highly responsive, with fast, robust equipment and a reliable high-speed internet connection, to minimize execution risk.

• Capital losses can occur if you experience slippage when placing orders.
• What is more, the exchange rate of a position may fluctuate, canceling out any gains you might have made through arbitrage trading.
• You should also consider transaction costs, which can reduce (or even cancel out) your profits.
• There is also a liquidity risk.
• Arbitrage is mainly the domain of professional and institutional traders.

Arbitrage trading helps traders profit from price differentials between markets or financial products. However, to minimize potential losses, you must also consider the costs and risks associated with this strategy.

In addition, you can use several types of arbitrage trading, such as M&A arbitrage, convertible bond arbitrage, volatility arbitrage, triangular arbitrage, and currency carry trade.