What is Arbitrage?

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DEFINITION:

There are a variety of investment strategies – but arbitrage is a short-term investment tactic in which an investor seeks to profit by buying one asset while selling that asset at a higher price in another market.

Understanding arbitrage

While investors seek profits in their own market, sometimes an opportunity presents itself in another market – the combination of the two is a tactic known as arbitrage. Some investors, after careful research and calculations, try to make profits by arbitraging the stock market. In arbitrage trading, an investor simultaneously buys and sells assets in two different markets that have different values, and then pockets the difference. As with all trading, arbitrage depends on the right timing. Investors who engage in arbitrage are called arbitrageurs, and they typically trade stocks, shares, or cryptocurrencies of their choice. In fact, arbitrage trading helps keep markets efficient because it draws attention to price discrepancies between different markets, which can even out prices.

EXAMPLE

Arbitrage trading is a bit like working at a bake sale even though you don’t like to bake. Imagine buying a tray of cookies at Costco for $0.25 each, turning around and selling them at a crowded bake sale in another area for $1.00 each. They’ve identified an opportunity: The value per cookie in the Costco tray was lower than the value per cookie when sold at the bake sale in the other city. When this happens in the stock market, it’s called arbitrage trading. An arbitrageur finds arbitrage opportunities in different markets, as in this case with the bake sale. Except that instead of buying and selling cookies, arbitrageurs can trade stocks and bonds. This strategy, known as arbitrage, is used by experienced investors seeking short-term gains that can help a long-term investment plan gain liquidity or cash flow.

Takeaway

Arbitrage is all about taking advantage of “the cookie scenario”…

An arbitrageur is something like someone who buys cookies cheaply from a bulk supplier and then sells them at a higher price at a bake sale. Arbitrage trading is about finding unique circumstances in different markets (such as a foreign market) that cause the same goods to be offered at different prices. This usually requires a thorough knowledge of the different markets and close monitoring of the news cycle. For traders, brokers and other investors, arbitrage can be a way to make calculated profits. However, this strategy also carries significant risks and isn’t suitable for most investors.

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