Arbitrage involves buying a security in one market and selling it simultaneously in another market at a higher price, allowing investors to profit from the temporary price difference per share. This strategy is applicable across various markets, including stock and currency trading.
In the stock market, traders utilize arbitrage by purchasing stocks on foreign exchanges where the share price hasn’t adjusted for the exchange rate, resulting in an undervalued price compared to the local exchange. This discrepancy enables traders to capitalize on the price difference and generate profits.
While arbitrage may appear complex to beginners, it’s a straightforward and low-risk trading technique.
In foreign exchange investments, arbitrage is a tactic where traders can secure profits by buying and selling an identical security, commodity, or currency simultaneously in two separate markets. This strategy allows traders to take advantage of the varying prices of the same asset in different regions involved in the trade.
An Example of Arbitrage
Consider this arbitrage scenario:
Nio Inc. is listed on both the Singapore Stock Exchange (SGX) and the New York Stock Exchange (NYSE).
Let’s say the stock is priced at $18.00 SGD on the SGX and $15.00 USD on the NYSE. With a USD/SGD exchange rate of $1.35, the $15 USD share should be equivalent to $20.30 SGD on the SGX. However, the actual SGX price is lower.
In this situation, a trader can buy Nio shares on the SGX for $18.00 SGD and sell the same stock on the NYSE for $15.00 USD. Considering the exchange rate, each share’s equivalent value should be $20.30 CAD. Thus, the trader earns a profit of $2.30 per share ($20.30 – $18.00).
What Makes Arbitrage Low-Risk?
The concept of “textbook” arbitrage is generally perceived as low- or no-risk because it doesn’t necessitate additional capital; it’s essentially buying in one market and selling in another. Due to the minimal price difference involved, the level of risk is typically low. However, real-world arbitrage often involves large-volume trades, leveraged capital, timing complexities, and other elements that elevate the level of risk.
While pure arbitrage is generally considered low-risk and involves minimal price differences, there are still potential avenues for losses. Traders encounter execution risk, counterparty risk, and liquidity risk, despite the small price discrepancies. Thus, arbitrage isn’t entirely devoid of risk, as there are limitations to its effectiveness.
When assessing arbitrage opportunities, it’s crucial to factor in transaction costs, as excessively high fees can offset potential gains from trades. For example, in the previously mentioned scenario, if the per-share trading fee surpassed $2.30, it would eliminate any profits.
How can traders use arbitrage?
Traders employ arbitrage strategies with Contracts for Difference (CFDs), derivatives that facilitate swift opening and closing of positions. Speed is essential in arbitrage, as faster reactions enhance profit potential.
Many traders opt for automated trading tools, alerts, and algorithms to execute their arbitrage plans. This eliminates the need for manual calculations, as the software promptly identifies arbitrage opportunities.
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