Have you ever wondered how some investors always seem to make money, even when the markets are moving down?
One of their secrets may be arbitrage.
Arbitrage is an investment strategy that involves exploiting price differences of the same or a similar asset between different markets.
By, for example, buying a currency cheaply on one market and selling it at a higher price on another market, you as an investor can make money on the price difference.
In this article, we'll take a closer look at what arbitrage is, different types of arbitrage, examples of arbitrage, how it works, and how you can use it in your investment strategy.
Key points
- Arbitrage is the buying and selling of an asset in different markets in order to exploit any price difference in the markets
- Arbitrage trading can be done with stocks, raw materials and currency
What is arbitrage?
As mentioned, arbitrage is about discovering and exploiting price differences between different markets or assets.
If we look at stocks, for example, arbitrage can occur when a stock is listed in two different countries. For example, the Chinese giant Alibaba, which is traded both in the US and on the German stock exchange.
Should a price rally occur on the Hong Kong stock exchange while at the same moment it is still trading at a lower price on the New York Stock Exchange (NYSE), there may be an arbitrage opportunity for you as an investor on the New York Stock Exchange.
In such a case, you could buy the Alibaba shares on the American stock exchange and exchange these shares for Hong Kong shares, and sell them on the Hong Kong stock exchange for an immediate profit (without counting brokerage and possible moving costs in this example).
You can read about a real incident that concerned Alibaba in this article from Yahoo.
Exchange rates in each country differ. This means that what you pay for the Alibaba share can – as you can see – vary between the two exchanges.
There are several different types of arbitrage trading. Here are two that investors can use:
- Financial arbitrage: This is a form of arbitrage where the investor buys a financial instrument, such as shares or bonds, cheaply in one market and sells it at a higher price in another market.
- Merger arbitrage: This is a form of arbitrage where the investor buys shares in a company that is in the process of undergoing a merger or being acquired, with expectation that the share price will increase to the agreed purchase price after the agreement has been completed. In recent times, Elon Musk's acquisition of Twitter and Microsoft's acquisition of Activison Blizzard are good examples of such a merger arbitrage opportunity.
Advantages and disadvantages of arbitration
Advantages:
- The opportunity to make money from price differences between different markets or assets
- The ability to make money even when the markets go down
Disadvantages:
- The need for a good understanding of the markets and assets
- Risk of losing money if the price difference is not used correctly or is changed
- Risk of regulations or other external factors that may affect the arbitrage investments
A few final words
To succeed in arbitrage trading, it is important that you have a good understanding of the markets and the asset in question, as well as the ability to trade quickly.
It is important to research and understand the risks before making an investment in arbitrage, and it may be wise to diversify your investments and not bet everything on one card.
You may also want to research and understand different types of arbitration. Maybe you'll do like Warren Buffett and run a merger arbitrage trade when the opportunity presents itself?
It's all about finding the one that best suits your investment strategy.
Read also: shares for beginners: a great guide to investing in shares and fund
My recommended tools
I recommend Finchat.io to you who are serious about investing in individual shares, who want detailed information on companies' key figures. You also get access to an AI chat dedicated to finance. Even professional investors use FinChat, and if you're a graph lover, this is for you.
Simply Wall St is for you who want to be served a simple overview of a company, in addition to getting their 'intrinsic value' via the cash flow method. It gives you a clue as to whether you are buying an underpriced or overpriced share - in a simple visual way.
