Traders are always looking for opportunities to make money. Being able to make a profit depends on a few different factors including the circumstances and conditions of the market, as well as good timing. These factors, along with a trader's risk tolerance and goals generally help shape his or her trading strategy.
Developing a strategy can help a trader ensure he or she gets regular results while avoiding behavioral finance biases. All of this is just as true for anyone trading in the foreign exchange market. One of the strategies traders use in this market is called arbitrage. This article outlines the basics of this strategy and how it's used in the investment world.
- Arbitrage happens when a security is purchased in one market and simultaneously sold in another at a higher price.
- This results in a profit from the temporary price difference.
- Arbitrage is considered a risk-free profit for the investor or trader.
- A trader tries to exploit arbitrage opportunities like buying a stock on a foreign exchange where the price hasn't yet adjusted for the fluctuating exchange rate.
What Is Arbitrage?
Arbitrage is basically buying a security in one market and simultaneously selling it in another market at a higher price, thereby profiting from the temporary difference in prices. This is considered a 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.
Example of Arbitrage
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 $63.50 CAD on the TSX and $47.00 USD on the NYSE. The exchange rate of USD/CAD is $1.35, which means that 1 U.S. dollar = $1.37 CAD. Given this exchange rate, $47 USD = $64.39 CAD.
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 $63.50 CAD and sell the same security on the NYSE for $47.00 USD—the equivalent of $64.39 CAD—netting them $0.89 CAD per share ($64.39 - $63.50) for the transaction.
Even when markets have a discrepancy in pricing between two equal goods, there is not always an arbitrage opportunity.
The Bottom Line
If all markets were perfectly efficient, there would never be any arbitrage opportunities—but markets seldom remain perfect. Another factor to consider is transaction costs. They 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.