What Is Arbitrage? Definition & Example
The arbitrage opportunity is not new, but it has been recently adopted by traders as a way to make money. Arbitrage exists when an investor takes advantage of a price discrepancy. Arbitrage trades are not illegal, but they are risky.
Arbitrage is the act of taking advantage of a discrepancy between two almost identical financial instruments. These are typically traded on different financial markets or exchanges. It happens by buying and selling for a higher price somewhere else simultaneously.
In this article we will discuss more about what arbitrage is, types of arbitrage, how it works and more.
Here’s What We’ll Cover:
What Is Arbitrage?
The definition of Arbitrage is the practice of making money by exploiting price disparities in different markets for the same asset. There must be at least two comparable assets with differing costs for arbitrage to occur. Traders can exploit this by buying for the lower price and selling for the higher price.
To better understand what arbitrage is, let's take an example. The stock of a company called "Coca Cola" (KO) is trading at $50.00 on the New York Stock Exchange and that same security is also trading for €48.85 EUR in Frankfurt (Germany). This means that there is a price difference between the two securities. This can be exploited by arbitrage traders by buying at a lower price, then selling at a higher price.
Types of Arbitrage
There are three types of arbitrage: cross-market arbitrage, inter-market arbitrage and intra-market arbitrage. Arbitrage also exists outside the realm of traditional securities. Some common examples are within crypto markets and Amazon. Keep reading to learn more about these arbitrage strategies.
This is where the transactions take place across different markets. If the price of the asset at one market is $40, and an equivalent asset can be bought on another market for $35, this is cross-market arbitrage.
This refers to transactions taking place between different types of assets. For example it could involve trading between the stock market and commodities.
This is when transactions are carried out within one market only. For example, intra-market arbitrage occurs if the price of a security drops below its intrinsic value.
Is Arbitrage Legal?
Arbitrage is not illegal by itself, but it does have risks associated with it. These include allocating capital poorly. You could enter into contracts incorrectly. This could result in the buying or selling of an asset at an unfavorable price.
What is Risk-Free Arbitrage? Does It Exist?
When traders talk about risk-free arbitrage, they are claiming complete certainty that you will make money off of a trade. This type of risk-free arbitrage does not exist. There is always some sort of risk associated with any financial transaction. It is impossible to be absolutely sure how prices for an asset will behave. However, arbitrage traders can do their best to ensure that the future price is trading within a small margin of error.
How Does Arbitrage Trading Work with Crypto-assets?
The most important considerations with crypto arbitrage are transaction costs and access to exchanges. Since the space is so new, transaction speeds are not always guaranteed. Arbitrage traders have seen high demand for Bitcoin on certain exchanges due to its fast processing times compared to other cryptocurrencies. Currency arbitrage is very popular.
Arbitraging crypto-assets requires having accounts registered on two different exchanges. You will also be paying transaction fees for both exchanges. This may be the biggest drawback of arbitraging crypto-assets.
What is Arbitrage on Amazon?
Another common example of arbitrage is with Amazon. You could have a retailer selling the exact same product on Amazon for different market prices. Depending on your buying power, you can buy from one retailer and sell it to the public for a small profit.
If you're looking for a side hustle, another popular option is to buy on sale items at big discounts at stores. You could also utilize markets like Craigslist or Facebook Marketplace. You can find low priced items. Then, you relist them on Amazon, Facebook, or Craigslist at a markup.
To sum it all up, arbitrage is the simultaneous purchase and sale of an asset. Traders do this to profit from temporary differences in price. Arbitrage can be broken down into three main types: cross-market arbitrage, inter-market arbitrage and intra-market arbitrage. Arbitrage can be profitable but there are no risk-free profits. There are also alternative opportunities for arbitrage in markets like cryptocurrency and online marketplaces.
Arbitrage can be a profitable way to make money, but it is not without its drawbacks. With careful analysis and planning , there are ways for those who know what they're doing to take advantage of arbitraging.
Hopefully, this article gives you enough information to get started in your buying and selling career!
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