Arbitrage trading: what is it and how does it work?

Arbitrage trading is a strategy that aims to take advantage of market inefficiencies. Find out how arbitrage works and the most popular arbitrage strategies.

What is arbitrage trading?

Arbitrage trading is a strategy that aims to take advantage of price differences across different markets.

In theory, arbitrage should be impossible as markets are efficient, all prices should represent the current market value. But small discrepancies do still exist due to geography and technology – for example, lags in information can occur as price data is transmitted from one location to another.

In a pure arbitrage play, a trader will find a currency, commodity or stock that is priced differently on two different exchanges. They’d buy at the lower price and sell at the higher price.

The concept is commonly likened to buying collectables – such as art, sneaker or antiques. People buy it in one place (in store) and sell it straight away in another (online marketplaces) for a profit. It’s not the asset that’s important, it’s the ability to leverage demand to your benefit.

Arbitrage trading example

Let’s say that company ABC has a dual listing in the UK and Australia. On the London Stock Exchange, the shares increase from £30.00 to £30.10, but on the Australian Stock Exchange, the shares are still at £30.00.

A trader could buy on the LSE and sell immediately on the ASX – earning 10p profit per share.

How arbitrage trading works

In its simplest form, arbitrage works by simultaneously buying and selling one asset on two different exchanges, or in two different geographies. The positions must be for high quantities to make any real return on the trade because the price differential will be so small.

Learn about high-frequency trading

That’s why most arbitrage trading is done using a margin trading account with leveraged derivatives – such as CFDs, futures and options. These enable traders to open a full position with just a fraction of the capital needed. For example, a GBP/USD position worth £20,000 with a margin factor of 3.33% would only require £666 to open the trade.

It’s important to note that your profit and loss will be calculated based on the full value of the trade – not your initial deposit. This can magnify your returns, as well as your risk, making it important to learn how to use risk management tools, such as stops and limits.

How to find an arbitrage opportunity

Finding a pure arbitrage opportunity is difficult, as advancements in pricing technology have made the discrepancies between exchanges disappear as quickly as they come.

Today, a lot of arbitrage opportunities are found by algorithms – complex programmes that identify price differences and execute trades automatically. This is known as statistical arbitrage and is most commonly performed by large institutions – such as hedge funds – who have access to the technology needed.

But, with the improvements in retail algorithmic offerings – such as MetaTrader4 – it is possible for individuals to find arbitrage opportunities too.

Stock trading arbitrage

As we’ve seen, a pure stock arbitrage opportunity usually involves a public company that has listings on multiple stock exchanges. But another common way of identifying a stock arbitrage opportunity is to look for undervalued companies that could be the subject of mergers – we’ll look at this technique more in a moment.

Forex trading arbitrage

Arbitrage in forex markets is more common because the market operates over the counter, through a network of banks and institutions. This means as price data travels through the decentralised system, there can be delays in price updates.

Plus, as exchange rates are volatile by their very nature, it’s not uncommon for two exchanges to be quoting different prices. Even if we take an everyday example of tourists looking to convert currencies, you can be quoted different prices by different currency businesses.

Arbitrage trading strategies

Let’s take a look at two of the more popular arbitrage strategies.

Triangular arbitrage

Triangular arbitrage is a forex arbitrage strategy. It involves using three currency pairs, so is considered a more advanced technique. The aim would be to benefit from the small exchange rate differences that exist by converting one currency to another, via a third.

Triangular arbitrage involves:

1. Using currency A to buy currency B
2. Using currency B to buy currency C
3. Using currency C to buy currency A

Let’s say you’ve got $100,000 and are quoted EUR/USD at 1.1580, EUR/GBP at 1.4694 and GBP/USD at 1.7050. Using triangular arbitrage, you’d:

1. Sell your dollars to buy euros ($100,000/1.1580) giving you €86,356
2. Sell the euros to buy pounds (€86,356/1.4694) giving you £58,770
3. Sell the pound to buy back dollar (£58,770x1.7050 giving you $100,202

Your position would have made $202 – excluding any extra costs you might have incurred, such as taxes.

The strategy requires buying very large amounts of each currency in order to make profits from the minute movements. It’s also important to note that these exchange rate opportunities only hold for a few seconds – if not less – so most FX arbitrage has to be performed by automated systems in order to execute quickly enough.

Merger arbitrage

Merger arbitrage strategies involve buying a company before a large announcement – usually a merger, as the name suggests – and selling after the deal is complete.

When a merger occurs, any outstanding shares of the target company have to be purchased by the acquiring company. In most deals, this would be at a premium to the stock’s current market value in order for shareholders to profit. As the merger becomes public knowledge, other investors will typically purchase the shares, and drive the price nearer to the announced deal price.

So, a merger arbitrage strategy involves attempting to predict whether a company will be taken over and purchasing the shares – or going long – before the deal is officially announced.

The price discrepancy isn’t immediate – and isn’t even guaranteed because the merger could fall through or never materialise.

Speculative traders could use this to their advantage though. For instance, by taking a short position on a target company’s shares when they believe the deal will fall through.

Typically, this strategy is far more long-term than most as it would lock up a trader’s capital for a greater period. It’s a common strategy for hedge fund investors or position traders.

Arbitrage trading platforms

As most arbitrage strategies rely on algorithms, it’s important to use a platform that’s suited to building automated systems.

With City Index, you can use MetaTrader 4 (MT4) as an arbitrage trading platform – as you can create your own algorithm or use off-the-shelf systems created by other users and Expert Advisors.

These Expert Advisors will set custom parameters according to your strategy. This means you can execute orders automatically within your set specifications and not have to manually scour markets for arbitrage trading opportunities.

MT4 also offers a range of indicators and add-ons to help supplement your arbitrage trading.

Arbitrage trading FAQs

Is arbitrage trading legal?

Arbitrage trading is legal in most countries – including the United States and the United Kingdom. It’s believed that the practice contributes to market efficiency by ensuring price discrepancies don’t last long. Although it’s not illegal, it can be risky so it’s important to manage your trading risk with stops and limits.

Is arbitrage suitable for day trading?

Yes, arbitrage is a common day trading strategy as the differences in price the strategy is based on only last a few seconds, making it suitable for very short-term trades.