How Arbitrage Works
Arbitrage can be utilized to make profits on various
types of financial transactions. Here is a look at
how arbitrage works.
Using arbitrage, an investor makes a profit by buying a product at one price, then selling it (almost
instantly) at a higher price, probably in a different market. Arbitrage isn’t limited to investment products
like bonds and commodities; it can happen with any type of financial transaction.
Stock arbitrage can happen when a stock is listed on two different exchanges at two different prices. An
investor, or arbitrageur, can buy shares of the stock on the exchange where it’s listed for a lower price
and sell them on the exchange where there’s a higher price. Stock arbitrage was easier in the past
before stock listings were done electronically. Now, price discrepancies are often corrected in as little as
a few seconds, leaving only a small window of time for stock arbitrage to take place.
Arbitrage can also happen with company mergers and acquisitions. Before a company mergers or is
acquired, it may offer a stock buyout in which shares of stock are sold. The share price of stocks from the
target company may decline shortly before the merger happens. During that time, an arbitrageur can
purchase the discounted shares and then sell them when the combined company’s stock rises.
Credit Card Arbitrage
With credit card arbitrage, the investor takes a 0% or low interest rate loan from the credit card. Then, he
deposits the cash in a high-interest rate savings account, CD, or some other type of investment that pays
a decent yield. Meanwhile, the investor makes minimum payments on the credit card, pockets their
interest earnings, and repays the loan before the low interest rate expires. You’ll need a high credit limit
and good credit score to qualify for low interest rate deals to make a good profit from credit card
arbitrage. You have to be careful with credit card arbitrage because simple mistakes, like a missed
payment, can forfeit your low interest rate.
In currency arbitrage, the investor takes advantage of
differences in currency conversions. For example, if one
bank has a higher exchange rate than another. It’s easy
for computer systems to correct these types of
discrepancies, so typically only sophisticated investors
make a profit from currency arbitrage.
Savvy sellers use eBay as a market for arbitrage, by
purchasing low priced items offline in stores, yard sales,
or thrift stores, then selling them for a higher price in
eBay. Some sellers even purchase low-priced items on
eBay, then relist them, tweaking the description, and
selling for a higher price. The same thing can be done using Craigslist or your local newspaper. Listing
on Craigslist is free, though, so there’s virtually no cost in Craigslist arbitrage.
By definition, arbitrage is supposed to be a risk-free transaction, but there is risk. For example, it’s
possible to lose money in arbitrage, if the price increases before you’re able to sell the good. With stock
and currency arbitrage, the price gaps may be closed before you get the chance to sell your stock. In the
best-case scenario, you’ll at least break-even on your transaction. However, there’s a chance you’ll lose
money in the trade.
Another risk lies not in the arbitrage itself, but in the presence – or lack of – of arbitrage opportunities.
You could spend hours looking for price discrepancies to take advantage of and never find any. And
once you spot one, you have to be ready to act. You’ll need to have the money on hand or a margin
account with enough available credit to make the arbitrage transaction.
There’s typically some type of transaction cost involved with arbitrage. It may be brokerage fees, eBay
listing fees, shipping fees, or balance transfer costs. In any case, expect to pay out some cash for the
If you like the idea of arbitrage, but don’t want do the work yourself, you can invest in an arbitrage fund
like ARBFX, which invests in mergers and acquisitions.
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