What Is Arbitrage Trading?

Arbitrage trading is considered a low-risk trading strategy that exploits market inefficiencies as the basis for profit-making. Market inefficiencies have to do with the variations in the value of an asset in different markets. Although the same asset ought to have an identical value everywhere, that is not always the case, and this is where arbitrage traders or arbitrageurs come in. Arbitrageurs create an opportunity by taking advantage of those tiny price differences… learn more in the body of the article.

Arbitrage trading is the buying and selling of an asset in different markets or under differing circumstances to profit from tiny discrepancies in prices. It is a form of trading that takes advantage of briefly existing variations in the price of an asset in different markets or online exchanges(if referring to cryptocurrencies) to generate a profit.

The major problem an arbitrageur faces is the ability to see opportunities and trade them quickly, because other traders will likely see the same price difference and rush to act, leaving the window of profit open to only those who can act quickly to actualize it. Some traders make use of algorithms or bots to monitor the market and trade assets in fractions of a second. On the other hand, with low risk comes low profit, meaning that for a trader to have a worthwhile arbitrage trade the capital required is usually very high.

TYPES OF ARBITRAGE TRADING

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There are different arbitrage strategies utilized by traders in various market environments to realize profits. Two will be discussed in this article, each from a different market sector.

MERGER ARBITRAGE

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Merger or risk arbitrage as it is often called is an occasion-driven trading strategy to gain from inefficiencies presented by a corporate event. An arbitrageur planning to benefit from the merging of two companies will purchase the stocks of the respective companies before the merging or acquisition is completed. The reason for this is that the prices of such stocks are bound to fall due to the uncertainty created by the probability that the deal might not be completed. The stocks are purchased before the merging are later resold for when the deal is finalized. Merger arbitrage comes with its risks since the completion of the deal is not guaranteed.

TRIANGULAR ARBITRAGE

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Touching on the market discrepancies in the world of cryptocurrencies, triangular arbitrage is a trading strategy used to exchange three coins for one another in a loop to buy back the initial one for a gain. By creating a loop starting with Bitcoin and exchanging it for Ethereum, exchanging Ethereum for Litecoin, and finally buying back the Bitcoin with Litecoin the trader only profits if the price difference between Bitcoin and each of the other coins is different from the spread between Ethereum and Litecoin.

RISKS INVOLVED IN ARBITRAGE TRADING

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Arbitrage trading is believed to be low-risk, but it still comes with minimal risks. A few of the problems involved in arbitrage trading could be execution-based, politically induced, or socially induced risks, e.t.c.

SOCIALLY INDUCED RISKS: In the case of cryptocurrencies there can be the issue of bearish markets at a time of crisis or societal hitches which will increase the volatility of assets and make prices fluctuate unpredictably.

EXECUTION RISKS: As an arbitrageur, quick decisions and even quicker execution of trades are a primary requirements for profit-making. Considering the competition of other arbitrageurs a trader may be unable to finish a trade before the variations in prices even out. For there to be gain the trader must buy on the market at a low price and sell off on the market with a high price in a limited time.

POLITICALLY INDUCED RISKS: For a merger, arbitrageur politics can be a deciding factor as to whether or not a profit will be realized. Politics can influence the finalizing of a merging or acquisition of a company into another which would result in a loss for the trader because they would have purchased the stocks already.

CLOSING THOUGHTS.

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Arbitrage trading is very beneficial for continued market efficiency as it ensures that prices never deviate substantially from standard value for extended periods. It is widely adopted by large firms due to the high capital requirements to make it worthwhile.



Author: Gate.io Observer: M. Olatunji
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