If you didn’t know this before now, there are lots and lots of ways to make (seemingly) easy money all around you.
Arbitrage is one of the quickest ways to make money around (short of robbing a bank). It is an opportunistic strategy that depends on making a profit off the disparate values of assets, commodities, or securities, without creating any additional value. It’s almost like spinning money out of thin air!
But that’s a bit of a simplistic take on arbitrage. In truth, arbitrage is a sophisticated trading or financial strategy that you’ll often find on major securities exchanges and usually executed by the most experienced traders. Although the concept itself is often tied to financial markets, it can be applied pretty much anywhere else, and with identical results.
If you have been wondering how to get 2021 off to a blistering start, arbitrage may be a financial strategy you can look more closely at. But keep in mind that there is no reward without risk. As is often the case, the higher the reward, the higher the risk – and this is no different for arbitrage.
What does arbitrage mean and how can you put it to work for you in 2021? Here’s all you should know.
What is arbitrage?
Arbitrage is a financial strategy that involves taking advantage of discrepancies in the pricing of equivalent, related, or identical products. Simply put, it means buying a product at a low value in one market and then selling high in another. The person carrying out the strategy (called an “arbitrageur”) makes a profit by simultaneously buying and selling the product in two different markets, without adding any value to it.
Arbitrage occurs in different circumstances and scenarios. One of the most common is in the financial markets where an asset is bought for a low price on one exchange and sold for a marginally higher price on another. For instance, you could buy shares of a company on the NYSE at $60, and then sell the same on the London Stock Exchange for $65. Here, you make a $5 profit for no other reason than that you were smart enough to notice the price differential and quickly take advantage.
As far as financial strategies go, arbitrage is one of the oldest around. Since wily old merchants first discovered the merits of buying spices and unique goods for next to nothing in obscure places and selling them for princely sums (and often, to princes) in more “civilized” areas, arbitrage has been a thing. Today, there are tons of arbitrage opportunities available in all kinds of places.
Types of arbitrage
There are many ways through which people make money with arbitrage. Some of these include the following:
- Currency arbitrage: As you have probably guessed, this type of arbitrage involves finding opportunities in foreign exchange. Currency arbitrage takes advantage of price discrepancies in the value of foreign currencies.
- Securities arbitrage: Here, the goal is to monitor stock exchange markets to identify price discrepancies in securities, and take advantage. Sometimes, the opportunity may be presented due to minor differentials in price caused by movements in the value of foreign currencies and their conversion.
- Risk/merger arbitrage: Risk arbitrage focuses on profiting from stocks involved in a merger or acquisition. Often, the strategy involves taking a long position on the shares of a target company (essentially betting that the value will rise), while balancing this with a short position on the shares of the acquiring company.
- Retail arbitrage: This is arbitrage as it existed in older times. These days, you can find people executing these types of arbitrage opportunities by flipping products they buy cheaply elsewhere on Amazon.
How does arbitrage work?
Most people who hear about arbitrage find one thing confusing – why does the price of the same product vary so much? If I could buy a pack of batteries at a mom and pop down the road for $2, why pay $2.50 for the same pack on Amazon? Why do share prices read differently on separate exchanges? Shouldn’t shares be priced the same across the board?
Well, that is one of the interesting things about arbitrage. In theory, it shouldn’t exist at all. There’s a handy economics theory that explains this. According to the market efficiency theory, in an efficient market, “equivalent assets should converge to the same price.” When prices change, they should be updated across the board swiftly and accurately.
However, markets are not always efficient, and they are seldom perfect. Sometimes, price changes may not reflect quickly enough across exchanges. In fact, sometimes a buyer may be willing to buy for higher than a seller is willing to sell. This could be because they’re more comfortable buying at a particular place, they think the free delivery is a game-changer, or just because of a difference in purchasing power. For whatever reason, they don’t mind the higher price. It is these circumstances that create arbitrage opportunities, providing you with a chance to get free money – if you’re smart (and quick) enough.
Why arbitrage is lucrative?
Arbitrage is generally regarded as a low-risk way to make quick bucks. Arbitrage opportunities typically have a low entry threshold. So long as you can produce the capital to take advantage of the situation, you should be counting relatively free money shortly.
One of the biggest attractions of the strategy is the fact that you do not have to produce any value. It’s almost like putting your money in a high-interest yield account and making some tidy interest – only, you don’t have to wait an entire year to enjoy it.
But that doesn’t mean arbitrage is all fun and games though. There can be significant risks to the entire venture, and if these risks are not well-managed, you could find yourself biting off more than you can swallow.
Risks of arbitrage
One of the downsides of arbitrage is that it requires perfect conditions to work well. Generally, you need:
- Impeccable information that lets you accurately tell where an opportunity exists;
- Swift purchasing and reselling processes;
- Low or zero transactional costs required to purchase or sell the asset;
- Low or zero transactional costs to exchange currency and/or take out your profits
- Minor or no tax exposure
Without at least most of these conditions in place, the arbitrage opportunity may not be worth it at all, if it even exists. In addition to these, there are several risks that you must look out for if arbitrage will work as you want. These include:
- Change in price: Volatility can be bad news for arbitrage, especially if the price rapidly and unexpectedly changes in the opposite direction to what you want.
- Use of leverage: In most situations, arbitrage requires the use of leverage. This basically means you borrow in order to take advantage of the opportunity. But if anything goes wrong, you’ll be the one left holding the bag.
- Short-lived opportunity: As a rule, arbitrage opportunities are short-lived. They typically exist for a fleeting instant (ranging from mere hours to days) before they’re gone. So you must be extremely fast to take advantage.
- Liquid asset: Lastly, the arbitrage opportunity needs to involve a liquid asset. Liquid assets can be bought and sold fairly quickly. If the asset is illiquid, then you may not have enough time to buy or sell the asset before the opportunity passes.
So, it’s important to keep in mind that arbitrage is not without its risks. But if you believe you have all your bases covered, it can provide a lucrative earning opportunity.