What is Market Arbitrage?
Market arbitrage refers to the simultaneous buying and selling of the same security in different markets to take advantage of a price difference between the two separate markets.
- Market arbitrage refers to the simultaneous buying and selling of the same security in different markets to take advantage of a price difference.
- Market arbitrage opportunities typically arise due to asymmetric information between buyers and sellers.
- Market arbitrage is, in theory, considered to be a riskless activity because traders are simply buying and selling equal amounts of the same asset at the same time.
Understanding Market Arbitrage
Arbitrage, by definition, is the exploitation of price differences on the same asset in different venues to gain a riskless profit. This is possible solely due to the fact that, contrary to popular belief, markets are not perfectly efficient. In a market arbitrage trade, an arbitrageur would sell the security that is priced higher in one market while, at the same time, buying that same security in the market where it's priced lower. The profit is the spread between the asset's price in the two markets.
Market arbitrage can only be a viable practice if an asset, that is traded globally, is priced differently in different markets. In theory, the prices for the same asset should be uniform across all market exchanges, but, the reality is that this is not always the case. This lack of uniformity gives rise to market arbitrage opportunities.
For example, if Company ABC's stock trades at $25 per share on the New York Stock Exchange (NYSE) and at $25.15 per share on the London Stock Exchange (LSE), an arbitrageur would purchase the stock for $25 on the NYSE and sell it for $25.15 on the LSE, thereby profiting by the difference in the price spread ($0.15/share) of that stock between the two exchanges.
Market arbitrage is, in theory, considered to be a riskless activity because traders are simply buying and selling equal amounts of the same asset at the same time. Again, the reality is that, while the notion of riskless profit is normally valid, the arbitrageur assumes the risk of price volatility in the offsetting markets. The price of a security in the offsetting market may rise unexpectedly and result in a loss for an arbitrageur.
Practicing Market Arbitrage Trading
Market arbitrage opportunities are uncommon and short-lived because security prices adjust according to forces of supply and demand. Essentially, the practice of arbitrage, in and of itself, should eliminate the arbitrage opportunity in short order.
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.