Our economic dictionary defines arbitrage as “the opportunity to buy an asset at a low price and then immediately sell it on a different market for a higher price.”
This can be easily illustrated with a real life example. Let us say a specific type of laptop is selling on eBay for $1000 and the same laptop is being sold in your local classifieds for $1200.
You could then buy laptops on eBay for $1000 and sell them in the classifieds the same day for $1200, making a neat little profit of $200 on every transaction.
Risk ArbitrageAnother aspect of arbitrage can be seen on the shares spread betting markets. One often finds that when a takeover is announced, the shares of the two companies involved immediately react to the announcement.
Let us take the example of company A and company B who are both in the diamond industry.
If it now becomes known that company A will be buying out company B at a premium to the current share price, the price of company B’s shares will usually shoot up immediately to a level just below the offered price. On the other hand, the price of company A’s shares will decline because investors are scared the deal might not go through.
When news of such a merger becomes known, it can often make sense to spread bet on shares in company B to rise and spread bet on shares in company A to fall. Eventually company B’s share price should increase to the level of the price offered by company A and you will realise a profit on the transaction.
However, there is an element of time involved with risk arbitrage, which makes this a more risky form of arbitrage than those mentioned in the first paragraph.
Spread Betting Spot Vs Futures ArbitrageFor various reasons it often happens that the spot price of a commodity differs from the price quoted on the futures market.
In theory, the price of an asset on the three-month futures market should be equal to the spot price plus the holding costs, e.g. interest, for three months.
If a discrepancy develops, an astute trader might benefit from buying one and selling the other.
Assume the price of the gold rolling daily spread betting market is $1500, but for some reason the futures price drops to $1490. A trader who now sells gold on the spot market and buys it on the futures market will make a profit of $10 per ounce when the future transaction matures, assuming that the prices converge on the futures expiry date.
Note that there is, theoretically, very little price risk involved here, since the position is fully hedged.
If the position is the other way round, e.g. the spot price of gold is $1500, and the three-month futures price is $1520, you should buy gold on the spot market and simultaneously go short on the futures market. Your eventual profit would be $20 per ounce, again assuming that the prices ultimately converge.
Cross Instrument ArbitrageThere are many other forms of arbitrage. As long as there exists some sort of price relationship between two trading instruments a trader can theoretically benefit from arbitrage if there should be a temporary disturbance of this relationship.
Let us take the example of soya oil and soya beans. Although we are talking about two very different products here, their prices are directly related and any disturbance in that relationship will normally be of a temporary nature.
For the sake of simplicity, let us assume that the price of soya oil is historically close to ten times the price of soya beans, for the same weight.
If for some reason this relationship is temporarily disturbed and the price of soya oil drops to only eight times the price of soya beans, a trader might assume that eventually it will return to the long-term ratio.
He would therefore sell soya beans and buy soya oil and realise a very nice profit if the two prices converge to the previous relationship again.
This type of trading is often also called relative value arbitrage because it relies on the relative value of two instruments returning to a long-term relationship.
Instrument ArbitrageInstrument arbitrage is when the price of the same product is quoted at different prices on different markets.
An example is the West Texas Intermediate (WTI) and Brent crude oil. Both reflect the price of oil, but the first one is more a reflection of US supply and demand while the second reflects the international market. There is, however, a clear link between the two markets.
Historically they do not usually differ with more than $2, but it sometimes happens that they differ with as much as $4 to $5. In fact the current gap between the two products is at all time highs near $20.
Arbitrage opportunities clearly exist here, but since there are different forces affecting the two markets, one should be careful not to think that the relationship is straightforward.
Arbitrage – A Word of WarningThe risk involved in all forms of arbitrage is what happens if what the trader assumed to be a temporary disturbance turns out to be a fundamental, long-term shift in the market.
In that case, the two prices might never return to the ‘normal’ level and your losses might grow bigger over time until you finally get out of the trade.
As a result it can be useful to keep up to date with the latest fundamental news for the markets concerned and to ensure you stick to your spread betting strategy, setting clear limits to your trade.
Arb’ing Digital CurrenciesAlso see Bitcoin arbitrage.
Spread betting and CFD trading carry a high level of risk to your capital and you may lose more than your initial investment. Spread betting and CFD trading may not be suitable for all investors. Only speculate with money that you can afford to lose. Please ensure you fully understand the risks involved and seek independent financial advice where necessary.