Loading the player...
A:

Arbitrage is basically buying a security in one market and simultaneously selling it in another market at a higher price, profiting from the temporary difference in prices. This is considered risk-free profit for the investor/trader.

In the context of the stock market, traders often try to exploit arbitrage opportunities. For example, a trader may buy a stock on a foreign exchange where the price has not yet adjusted for the constantly fluctuating exchange rate. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange, and the trader can make a profit from this difference.

[Note: Many day traders look for arbitrage opportunities following mergers or acquisitions. For example, a to-be-acquired company may trade below the acquisition price due to the risk of the transaction falling through. Investopedia's Become a Day Trader course takes a look at this and other strategies that day traders can use to profit.]

Here is an example of an arbitrage opportunity. TD Bank (TD) trades on both the Toronto Stock Exchange (TSX) and the New York Stock Exchange (NYSE). Let's say TD is trading for CAD63.50 on the TSX and USD47.00 on the NYSE. The exchange rate of USD/CAD is 1.35, which means that 1 U.S. dollar = CAD1.37. Given this exchange rate, USD47 = CAD64.39. Clearly, there's an opportunity for arbitrage here as, given the exchange rate, TD is priced differently in both markets. A trader can purchase TD shares on the TSX for CAD63.50 and sell the same security on the NYSE for USD47.00 (the equivalent of CAD64.39), netting them CAD0.89 per share (64.39 - 63.50) for the transaction.

If all markets were perfectly efficient, there would never be any arbitrage opportunities — but markets seldom remain perfect. It is important to note that even when markets have a discrepancy in pricing between two equal goods, there is not always an arbitrage opportunity (For more on market efficiency, check out our article "What is Market Efficiency?")

Transaction costs can turn a possible arbitrage situation into one that has no benefit to the investor. For instance, consider the scenario with TD Bank shares above. If the trading fees per share or in total costs more than the total arbitrage return, the arbitrage opportunity would be erased.

RELATED FAQS
  1. How do I use the news to find arbitrage opportunities?

    Learn what risk arbitrage trading is and how this type of arbitrage trading opportunity is available to individual retail ... Read Answer >>
  2. What is the difference between arbitrage and hedging?

    Dive into two very important financial concepts: arbitrage and hedging. See how each of these strategies can play a role ... Read Answer >>
  3. How do I use an arbitrage strategy in forex trading?

    See how forex arbitrage acts upon opportunities presented by pricing inefficiencies through the buying and selling of different ... Read Answer >>
  4. What is the difference between arbitrage and speculation?

    Arbitrage and speculation are very different strategies. Arbitrage involves the simultaneous buying and selling of an asset ... Read Answer >>
Related Articles
  1. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  2. Trading

    Make Money Through Risk Arbitrage Trading

    Risk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
  3. Investing

    How Statistical Arbitrage Can Lead to Profits

    Find out how statistical arbitrage is leveraged by traders and investors seeking profit by capitalizing on the relationship between price and liquidity.
  4. Investing

    3 Mutual Funds Focusing on Arbitrage Profits (MERFX, ARBFX)

    Get details on three of the most popular mutual funds for investors interested in arbitrage trading.
  5. Trading

    Why Is Arbitrage Trading Legal?

    Not only is arbitrage legal in the US and most developed countries, it can be beneficial to the overall health of a market.
  6. Investing

    Arbitrage Pricing Theory: It's Not Just Fancy Math

    What are the main ideas behind arbitrage pricing theory? Find out how this model estimates the expected returns of a well-diversified portfolio.
  7. Trading

    Trade Takeover Stocks With Merger Arbitrage

    This high-risk strategy attempts to profit from price discrepancies that arise during acquisitions.
  8. Investing

    Hedge Funds Hunt for Upside, Regardless of Market

    Hedge funds seek positive absolute returns through aggressive strategies to make this happen.
  9. Personal Finance

    What Are the Risks of Credit Card Arbitrage?

    Find out why credit card arbitrage is a major gamble with devastating risks for those trying to beat the credit card companies at their own rate game.
  10. Trading

    Put-Call Parity and Arbitrage Opportunity

    These trades are profitable when the value of corresponding puts and calls diverge.
RELATED TERMS
  1. Market Arbitrage

    Market arbitrage refers to purchasing and selling the same security ...
  2. Fixed-Income Arbitrage

    Fixed income arbitrage is an investment strategy that realizes ...
  3. Currency Arbitrage

    Currency arbitrage is the act of buying and selling currencies ...
  4. Dividend Arbitrage

    Dividend arbitrage is an options trading strategy that involves ...
  5. Conversion Arbitrage

    An options trading strategy employed to exploit the inefficiencies ...
  6. Political Arbitrage Activity

    An arbitrage activity that involves trading securities based ...
Hot Definitions
  1. Intrinsic Value

    Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
  2. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  3. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  4. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  5. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  6. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
Trading Center