Arbitrage Investing: What You Need to Know

Arbitrage investing.

It looks and sounds fancy. It might seem a little complicated, too. 

But it’s actually a simple concept to understand. Simply put, you’re profiting from market inefficiencies. If done correctly, you can make a generous profit doing it.

Want to learn how to do it? Below, we’re sharing what you need to know about arbitrage investing.

What Are the Types of Arbitrage?

Arbitrage can work in many ways across different industries. Here are a few examples of arbitrage:

• Retail arbitrage: Buying retail products — from your local flea shop, for instance — and selling it elsewhere for more, like eBay.
• Geo arbitrage: Relocating to a lower-cost area while maintaining your income — often popular with people who make money online.
• Amazon arbitrage: Amazon arbitrage is when you source items for cheap — often from store sales and clearance racks — and then selling it on Amazon for profit.
• Media Buying Arbitrage: Promoting and monetizing content
• Foreign currency arbitrage: Capitalizing on currency exchange rates to maximize your returns after conversion. 

An Example of Currency Exchange

For example, David Alexander of Mazepress says, “ As a web designer and marketing consultant working with clients around the globe, I use arbitrage by billing customers in their native currencies and then holding onto them until I can convert them at a higher value. I spend each year moving between different countries including the UK, USA and other countries that accept the US dollar (more than you would imagine). Depending on where I am at the time and which currency I need most on a day-to-day basis I will transfer currencies only when it makes sense to do so. Since 2013 I have also been accepting cryptocurrencies including Bitcoin and Ethereum which have presented lots of opportunities for growing the revenue generated by client work. If you have the means to be patient, arbitrage can be a great way to grow your existing revenue, especially if you work with an international clientele.” 

This is just a shortlist of the ways you can use arbitrage. Each method has its own nuances to learn and master. For this article, though, we are applying arbitrage to investing. We will discover how you can exploit price differences when buying and selling stock shares to net nearly risk-free profit.

What is the Concept of Arbitrage Investing?

Arbitrage investing is all about exploiting the price differences between assets in two markets. 

When there is a price difference, arbitrageurs are quick to spot them. They will buy the investment from the market at the lower price and then sell it to the market at a higher price.

The difference is the profit they take home.

What is an Example of Arbitrage?

The arbitrage process can be easier to understand with a few scenarios. Let’s look at some examples to deepen your understanding:

A Simple Analogy

To help you understand this concept, let’s use an analogy.

In City A, the market is selling keychains for $2.00. In City B, the market is selling identical keychains for $5.00.

Obviously, you’ll want to sell keychains in City B, where you can make more. So, how can you leverage the difference between the two prices?

This is where arbitrage comes in.

It follows the buy low, sell high concept. You would buy keychains from City A and sell them in City B.

So, if you buy ten keychains from City A, you would spend $20. After you sell them in City B, you would make $50. That’s a $30 profit, nearly risk-free.

A Simple Example

Let’s translate this into buying stocks.

On the New York Stock Exchange (NYSE), you find Company C selling a stock share at $25. You then look check out the Japan Exchange Group (JPX) and find the same stock share selling for $26. 

You can buy the stock from the NYSE for $20 and then sell those shares on the JPX for $26. This will net a profit of $1 for each stock share sold.

You can then repeat this process until:

1. The stock is unavailable on the NYSE, or
2. Both stock markets adjust their prices where arbitrage is no longer possible.

Factors that Affect Arbitrage Investing

Different Valuation

In a perfect world, a stock share would cost the same across all stock exchanges. Each market would use the same valuation method and arrive at the same price. This follows the no-arbitrage principle. 

But this doesn’t apply in the real world. Different markets price assets differently. And it’s this fluctuation that makes arbitrage possible.

Assets don’t trade at the same price across all markets. Stock X might be selling at $100 on the NYSE. You may also find Stock X selling at $90 on the Chicago Stock Exchange. Each market is using different asset valuations.

Price Convergence

The price discrepancy between the identical assets in different markets won’t stick around forever. The price in both markets will converge, eliminating the price difference. 

The reason for this is the shift in supply and demand.

If you’re buying stock shares from Market A and selling it to Market B, what happens? In Market A, demand increases, and the price goes up. In Market B, the supply increases, and the price goes down.

While other factors come into play, this offers the most simplistic explanation. 

What it means for the arbitrageur is that you can’t exploit the price differences on only a handful of stocks. You will be on an ongoing lookout for price differences for many stocks across many markets.

Simultaneous Trade Execution

A price discrepancy might exist for only a few seconds. Specific software can identify a price difference within seconds. And just as quickly, the skilled arbitrageur must exploit that difference before it disappears.

For this to happen, the purchase and sale of a stock asset must happen simultaneously. If a purchased stock isn’t sold immediately, the stock share’s price might even out or drop. Instead of making money, you might lose money if you go into arbitrage investing unprepared.

Is Arbitrage Illegal?

Arbitrage is entirely legal. There is no insider trading. No gaming the stock market. You’re engaging in the same behavior as any other trader: buying and selling stocks. As an arbitrageur, you take it to the next level by capitalizing on price differences and executing trades for a profit. There is nothing illegal about this.

Is Arbitrage Trading Really Risk-Free?

Is anything in life honestly risk-free?

In most scenarios, the answer is no. With arbitrage investing, the risk tends to be minimal. But again, this is only if you’ve met the necessary conditions. One of those conditions is having access to automatic trade-alert and remote-alert software.

Remember: price discrepancies between two identical assets may last only nanoseconds. If you have the right equipment, arbitrage investing can be a relatively low-risk practice.

Pure Arbitrage vs. Risk Arbitrage

In investing, there is pure arbitrage and risk arbitrage. Here’s what you need to know about both. 

Pure Arbitrage

Pure arbitrage is mostly what you have learned so far. It happens when you identify price discrepancies between two identical stocks. You then exploit this price difference by buying the stock share at its lower price and then selling it at a higher price. The difference is the profit you make.

Pure arbitrage is largely low-risk. If you successfully buy and sell the stock within the expected time frame, your investment return is nearly guaranteed.

Risk Arbitrage

Risk arbitrage occurs after a company announces a merger and acquisition. This is a more involved strategy and carries more risk.

To understand risk arbitrage, let’s look at an example.

Let’s say that ABC Company plans to acquire XYZ Company. The price per stock share for XYZ Company is $25. ABC Company will acquire XYZ Company at $30 per share.

You learn that the merger will complete in six months. After six months, the deal closes. If all goes well, you sell your stocks at $30 per unit. This will net you a $5 profit for each stock share sold.

But there’s a risk — hence the name, risk arbitrage.

Let’s say you buy 1,000 stock shares of XYZ Company. A few months in, you learn that the deal fell through. By now, the stock price could be the same or may have fallen. You run the risk of actually losing money.

Which is Better?

The debate between pure and risk arbitrage is up to the investor’s comfort with risk exposure. It shouldn’t suggest, however, that one should be exclusive to the other. 

Pure arbitrage relies on technology and quickness to complete the transaction. The price discrepancy lasts mere seconds.

More speculative risk arbitrage requires more investment savvy. It encourages investors to make sound decisions based on company research and market trends.

The saying that the greater the risk, the greater the reward can also apply in this debate. In pure arbitrage, the price difference is often nominal. It would require you to purchase a large number of stock shares before you see a noticeable return on your investment. 

WIth risk arbitrage, your return on investment can be significant. Of course, this would vary from case to case. But it does present an exciting opportunity for savvy investors seeking a challenge.

Steve Case says venture capital is missing out on a 'great arbitrage'

Entrepreneur-turned-venture capitalist Steve Case sees a shift in startup funding money that’s moving from hotspots like California to the middle of the country.

At the Greenwich Economic Forum earlier this month, the founder of Internet pioneer AOL told attendees that California — particular Silicon Valley — will remain the preeminent ecosystem. However, he argued there's a "great arbitrage" happening in the middle of the country, and venture capitalists are missing out on it.

"It's crazy that essentially we're putting all our eggs in that basket and we're not diversifying more,” Case said.

“And, we're missing out, as investors, on what's a great arbitrage because the valuations in other places around the country, because of the classic Econ 101 supply and demand, are lower,” he added.

Case pointed out that venture capital overwhelmingly flows to a small group of coastal states. According to the National Venture Capital Association (NVCA), 75% of startup cash in 2018 went to California, New York, and Massachusetts. More than 50% went to California alone, the data show.

(You can read more about Steve Case’s net worth and how he made his money here.)

Arbitrage Investing: Pros and Cons

Arbitrage is an interesting trading strategy that could potentially earn you tons of profit. But it does have its disadvantages, as well. Let’s take a look at the pros and cons:

Pros

• Low Risk: If you can buy and sell the stock simultaneously during the price discrepancy, your net profits are nearly free from risk.
• Volatility Doesn’t Matter: If you think about it, the volatility of a stock share has little to do with arbitrage investing. Arbitrage investing, instead, relies on the market inefficiencies. Your returns are not based on the stock’s performance. Instead, it relies on the asset’s value difference between two different markets.
• Rewards Those Who See Market Shifts: Arbitrage investing doesn’t occur within a bubble. It’s affected by real-world events in business. If you can understand where the money is flowing, you can capitalize on valuation differences in other markets. Venture capitalist Steve Case noticed “startup funding money that’s moving from hotspots like California to the middle of the country.” This is creating what Steve Case calls a “great arbitrage.” If you can spot opportunities like this, you’ll fare well in arbitrage investing.

Cons

• Technology Requirements: Arbitrage investing is nearly impossible without the aid of technology. Mispriced asset differences might disappear within seconds. That's why automatic trade-alert and remote-alert software is necessary. It ensures that you can spot price discrepancies as soon as they arise. In the next instant, the software can simultaneously execute the buying and selling of the stock shares.
• Capital Requirements: If you expect to see significant returns in arbitrage investing, there are some capital requirements. First, you must have the capital to purchase the software needed to identify price discrepancies and automatically buy and sell stocks. Next, you should expect to purchase large quantities of stock shares to maximize your profits. This is because the price discrepancies of an asset can sometimes be a few dollars, sometimes even cents.
• Mergers and Acquisitions Can Be Risky: If you’re involved with risk arbitrage, the risk you’re exposing yourself to can be significant. The deal may collapse, and you could wind up losing your investment.
• Transaction Fees: Just because there is a price difference between the two stocks doesn’t mean there is an opportunity for arbitrage. In addition to fluctuating prices, you must also be aware of any transaction costs. These fees apply when a trader buys or sells the stock and will diminish your net returns. 

Is Short Selling Arbitrage?

In investing, when an investor has long positions, that means that they have already purchased and now own a specific share of stocks.

A short position, in contrast, means that the investor owes those stock shares to somebody but does not yet own them.

You might be wondering how you can owe somebody stock shares without owning them yet.

In investing, there is a stock options market, where you can sell stock shares without owning them. When another investor purchases them from you, you must secure the stock shares in time to complete the transaction. This is a complex investment strategy, and we have a guide on selling stock options if you’re interested.

But is selling short arbitrage?

Some might argue no, and others may say yes. Short selling can often fall under the purview of risk arbitrage. When you hear about a merger and acquisitions, you can short a stock share at a higher price while buying it at the lower price. This follows the philosophy of exploiting an asset’s price discrepancy. Of course, shorting a stock does present its own risks that you should know.

Is Arbitrage Good for the Market?

We are learning that arbitrage investing may actually harm the market. 

High-speed traders cost regular investors almost $5 billion a year, study says

A study by the U.K.’s Financial Conduct Authority found that the high-speed trading practice of “latency arbitrage” causes the overall volume of trading on global stock markets to decrease. This essentially imposes a “tax” on other investors, according to the study, costing as much as $5 billion per year across global exchanges. “In aggregate, these small races add up to meaningful harm to liquidity,” the FCA said.

Arbitrageurs leverage technology unused by average investors. This gives them an advantage when trading stocks, which can discourage other investors. The article points out that “better prices are snatched up by high-frequency traders before regular investors. The arbitrage practice also has the effect of reducing the incentive for those on the other side of a trade to offer these better prices.”

There is no definitive evidence that arbitrage investing has any long-term adverse effects on the market. Again, arbitrage is entirely legal to do.

The Bottom Line

Arbitrage is an investment practice that requires a keen eye and patience. More importantly, it will require significant capital. This capital will buy software that will automatically alert you of price discrepancies. It will also automatically trade those assets on your behalf. Without those, arbitrage investing is nearly impossible.

But the human element still has its advantages. If you want to engage in risk arbitrage, it will require you to make sound decisions on business acquisitions and market trends. With enough experience, practice, and creativity, arbitrage investing can be a profitable opportunity.

Inside The One Percent, we’re taking a close look at how to make money with arbitrage. Buy low, sell high is the most basic strategy for making a profit. The Capitalism.com team found a handful of things that people are buying and selling at a profit right now, and it’s a great way to build a business in any economy.

If you or someone you know is looking for a new side hustle, this is a really fun one.