What is Market Arbitrage
Market arbitrage refers to purchasing and selling the same security at the same time in different markets to take advantage of a price difference between the two separate markets.
BREAKING DOWN Market Arbitrage
In a market arbitrage trade, an arbitrageur would short sell the higher priced stock and buy the lower priced one. The profit is the spread between the two assets.
The market arbitrage practice is rooted in the assumption that an asset that is traded worldwide is priced differently in different markets. That is, the same stock may have a market value in Europe that is different from its value on the New York Stock Exchange (NYSE). In theory, the prices for the same asset on both exchanges should be equal at all times, but market arbitrage opportunities arise when they're not. Market arbitrage is a riskless activity because traders are simply buying and selling equal amounts of the same asset at the same time. For this reason, arbitrage is often referred to as "riskless profit."
For example, if Company ABC's stock trades at $5 per share on the New York Stock Exchange (NYSE) and the equivalent of $5.05 on the London Stock Exchange (LSE), an arbitrageur would purchase the stock for $5 on the NYSE and sell it on the LSE for $5.05 and pocket the difference of $0.05 per share.
Practicing Market Arbitrage Trading
Despite the popular characterization as "riskless profit," there is plenty of risk that the price of a security in the offsetting market may rise unexpectedly and result in a loss for an arbitrageur. In theory, market arbitrage opportunities are short-lived because security prices adjust according to forces of supply and demand.
Profiting from market arbitrage opportunities requires significant capital, which is why institutional investors and hedge funds are the ones capable of profiting from market arbitrage opportunities. Spreads between unequally priced securities is usually only a few cents.
Market arbitrage opportunities typically arise due to asymmetric information between buyers and sellers. While the efficient markets theory indeed works, markets have not always shown themselves to be 100 percent efficient. One such occasion of market inefficiency is when one seller’s ask price is lower than another buyer’s bid price, also known as a “negative spread.” For instance, this may happen when one bank quotes a particular price for a currency while another bank is referencing a different price. When a situation like this arises, it creates an opportunity for market arbitrage; however, it takes a well-trained eye to spot these opportunities.