What is Arbitrage?

Mon May 17, 2021, 06:31 pm | by Dan Schmidt | No comments

When I was in grade school, I used to know the favorite Starburst flavors of all my friends. I was the oddball who liked the lemon Starbursts while most of my classmates preferred cherry or orange. Of course, the trick was to act as if I didn’t like the lemon ones.

I’d often present a trade – 1 cherry Starburst from my pack for 2 of the lemon Starbursts from a friend’s pack.  Since I knew who liked cherry best, the deal was usually agreed upon and I went back with 2 Starbursts that I valued more than the single cherry one I had given away. Now if I found someone else who liked lemon, I could offer them a lemon for a cherry and repeat the process all over again. Yes, dentist visits were frequent at that age.

I didn’t know it at the time, but I was engaging in arbitrage. The value of the lemon and cherry Starbursts differed depending on who you went to. I utilized my knowledge of Starburst price sensitivity amongst various parties to extract maximum candy value. Of course, arbitrage isn’t a concept unique to lunch snacks. Assets often are valued differently depending on who holds them or where they are held. Arbitrage opportunities in markets are often brief and the risks are far greater than cavities. But many successful investors have leveraged arbitrage into wild profits, including some of the most recognized names in the industry.

What is Arbitrage, and How Does it Work?

Arbitrage is the process of buying an asset in one market while simultaneously selling it in another market. Arbitrage traders take advantage of small price discrepancies across markets and profit off the difference in these prices. In the example above, the cherry Starbursts had a different ‘price’ depending on the market (or classmate) you engaged with. This happens frequently in markets all over the globe.

In order for arbitrage to be successful, a couple conditions must be present. First, you need to have perfect pricing information. If the asset in question has two different prices at two different markets, the arbitrageur must know the exact price of each in order to properly calibrate the trade. Incomplete pricing information can result in a trade where transaction costs eat up profits. 

The second condition for arbitrage has become commonplace thanks to the rise of computer trading. We won’t delve into Efficient Market Hypothesis arguments here, but the truth is that arbitrage situations are quickly erased by fast-moving traders. Like moths to a lightbulb, arbitrage draws out opportunists who will whittle price discrepencies down to parity. In order to profit off arbitrage, you need to buy and sell instantly before the price catches up.

Where do arbitrage opportunities exist? Everywhere! Commodities often have slight price variations depending the market, cryptocurrencies are priced differently at different exchanges, and even stocks can be arbitraged using spreads. From your local yard sale to the largest financial markets on Earth, arbitrage is everywhere but always fleeting.

Example of Arbitrage 

Most traders think of arbitrage as a risk-free profit because a price divergence is instantly sold for profit. While many examples from business history aren’t exactly risk-free (and some have been disastrous), it’s often a quick and painless trade. Here’s an example that doesn’t involve candy.

Let’s say Company AAA has both equity and convertible bonds trading on public markets. Convertible bonds are a special type of debt that can be converted to common stock at in certain situations. Since these bonds are linked to the underlying stock, a certain correlation often forms between the bond price and the stock price. If AAA stock spikes, an arbitrageur may have the opportunity to buy the bonds before they ‘catch up’ to the price of the stock. By going long the bonds and shorting the common stock, the trader would instantly profit on the price discrepancy. 

If this trade sounds familiar, it’s because Citadel chief Ken Griffin executed a similar trade in 1987 when the market crashed and convertible bonds were hit much harder than their underlying common stocks.

Benefits of Arbitrage 

  • Quick Profits – In most classic example of arbitrage, the rewards are instantaneous. Sure, ‘instantaneous’ may be stretched out in certain situations, like when George Soros took a month to make his $1.5 billion currency arbitrage trade against the Bank of England in the early 90s. But profits are quick by nature since the opportunities aren’t present for long.
  • “Risk Free” – Arbitrage opportunities occur when prices diverge, so as long as the trader acts before the divergence is rectified, there’s usually no risk involved. But this one’s in quotes for a reason; more on that later in the cons.
  • Available Across Asset Classes – If you aren’t familiar with currencies and feel more comfortable with stocks and bonds, you can still find arbitrage trades. Only deal with cryptocurrencies? You can find discrepancies in futures and crypto prices amongst various exchanges. Even physical gold and gold futures can be arbitraged if the opportunity presents. No matter which asset classes you feel comfortable with, you’ll find potential arbitrage trades.

Cons of Arbitrage 

  • Short-lived – If you aren’t quick to act, you could see a profitable trade dissolve before your eyes. Prices never stay out of whack for long when markets are at work and discrepancies converge quickly regardless of industry or asset class.
  • Capital intensive – Price divergences are never wide chasms. Markets are usually somewhat efficient and when prices split, it’s by a slim margin that’s inevitably corrected. Because these gaps are small, profit margins are also tight so lots of capital is required to make the trade profitable. And if you don’t have the capital, you need to resort to leverage. And leverage is risky, even in ‘risk-free’ arbitrage trades.
  • Really risk free? – Overconfidence is a weakness that preys upon the best and brightest in any field and investing is no different. Arbitrage trades that seem risk-free at first could eventually turn into disasters should leverage be applied or a black swan event occur. Long-Term Capital Management used to arbitrage price differences between similarly dated US treasuries (usually the 30-year and a slightly shorter duration bond). The trade worked perfectly – until it didn’t. Russia surprisingly defaulted on it’s bonds and panicked investors piled into safe 30-year treasuries, nuking LTCM’s arbitrage trade and sending the financial system into disarray. 

Final Thoughts 

Arbitrage trading is one of the oldest and most successful techniques in history because opportunities are plentiful and the profits are quick and (relatively) painless. Markets are usually efficient, but price distortions do occur and no asset class is immune. 

You’ll need to have a couple things to take advantage of arbitrage: up-to-the-second price information, enough capital to profit, and the instruments necessary to make trades quickly. Hedge fund managers like George Soros and Ken Griffin have all these at their disposal, but retail traders usually don’t. 

Even if the risk in your trade is low, you never want to consider a large position to be completely risk-free. Unexpected events aren’t as rare as we like to believe and even a well-planned arbitrage trade can backfire. Remember, LTCM had multiple Nobel Prize winners on staff and loads of expertise and technology – and they still nearly bankrupted the financial sector.