How Arbitrage Works

Arbitrage can be utilized to make profits on various types of financial transactions. Here is a look at how arbitrage works.

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

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.

Merger Arbitrage

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.

Currency Arbitrage

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.

eBay 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 transaction.

Arbitrage Fund

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.