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There are various trading techniques and investors should learn more about them before the beginning of their trading careers.
One of them is called arbitrage. This is a trading technique which involves buying an asset from one market and selling it to a different marketplace. The purpose is to make a profit from a potential difference between the prices on the two markets.
This article will be exposing the mechanism behind it and how to use it.
What Is Arbitrage Trading?
Intraday trading is one of the most dynamic, unpredictable and fast-paced investment environments. Good day traders know the ropes of day trading and take advantage of all the discrepancies on different markets. Day trading is based on numerous trades on a daily basis. Therefore, participants use arbitrage all the time.
Unlike investors who really buy securities and wait for years to make a profit from them, traders actually speculate. They do not buy anything real, but rather place positions every day and make money.
Following the universal law of supply and demand, it’s logical to assume that these price discrepancies last for a short period of time.
Well, if an asset is very affordable and at a low price, then buyers will start purchasing. Therefore, the price will increase immediately and the market will balance out. For this reason, only day traders can benefit from this strategy because any differences in prices are fixed shortly.
For the purpose, I’m going to take two major exchanges– NASDAQ and the New Your Stock Exchange. Let’s image we have a company called Joy and their stocks are listed on both exchanges.
George is a day trader and notices that Joy’s stock is listed on the NASDAQ for $3.5 and $3.75 on the NYSE. He buys 1,000 shares on the Nasdaq for $3,500 and sells them for $3,750 on the NYSE. He has made a 250-dollar profit.
Are There Any Risks?
Ok, let’s think and refer to the above-mentioned example. George buys 1,000 shares at $3.5. By the day he lists them on the other exchange, the price is fixed and is also $3.5. It cannot go lower since this is the same company. He sells the shares at the same price. He wins nothing, he loses nothing. So, in theory, arbitrage is almost riskless.
You should be careful because there are situations that involve some risk when arbitraging. A particular example is when traders use arbitrage during or prior to mergers. A merger is the process of combing two companies. If a trader buys shares from the company which will be merged, he risks losing money.
Why? Well, it is never certain that a merger will happen.
Is Arbitrage For Everyone?
Yes and no.
Unfortunately, arbitrage is an option that suits the needs of institutional investors.
The reason for this is the huge amounts of money they have and could potentially invest. Usually, the discrepancies between prices are really small and a trader must purchase a lot of shares to have an impact and profit. Also, there are trading fees that are quite unbearable for individual investors. They do not have these resources to take advantage of this.
Technology And Arbitrage
As time goes by and technology develops more and more by the day, the less likely arbitrage is to work in the future.
In the past, people didn’t have our means of communication and the Internet did not exist. Therefore, plenty of mistakes could arise, leading to differences and discrepancies. The current conditions have limited arbitrage opportunities significantly.
Nowadays, thousands of investors could spot a difference and try to act as soon as possible. This will eventually lead to an increase in price and there will be no more a difference in the price of an asset.
On the other hand, this ensures and somehow regulates the stability of the market.
Types Of Arbitrage
- Municipal bond arbitrage
- Merger arbitrage
- Depository receipts
- Covered interest arbitrage
- Uncovered interest arbitrage
E-commerce arbitrage is an interesting and profitable concept which any investor can utilize. This is particularly suitable for individual investors since it is much more affordable. The online space nowadays offers so many opportunities that it would be a shame not to benefit from them.
Using arbitrage to purchase items from one marketplace and sell them on another is a good idea.
For example, if you know how to research items which are difficult to find and manage to sell them on Amazon, you might end up making some nice profit. Additionally, many people browse local flea markets or buy goods at a low price and then sell them on eBay or Amazon.
Well, there are, of course. Sometimes you can buy something for a decent amount of money and you want to double the price but there are no buyers. This is particularly relevant if we talk about collectible items or antiques.
Arbitrage is a trading technique that allows investors to benefit from short-term discrepancies in the price of an asset on two markets. However, primarily institutional investors can take advantage of this practice since they have all the necessary resources. On the other hand, individual investors might try online or ecommerce arbitrage.
Due to the advanced technologies and widely spread means of communication, mistakes rarely occur. Consequently, there are fewer and fewer deviations on the market. And when such happen, they regulate the market. Traders actually help make the market more stable and fix all errors.
The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.