Complete Guide to Arbitrage Trading

Did you know that there is a form of short-term trading that even Warren Buffett approves of?

While the investment legend is famously against anything resembling a get-rich-quick scheme, Warren Buffet is not only a supporter of arbitrage trading but also an active participant in it.

Indeed, unlike day and swing trading which can boast of being fairly controversial, arbitrage trading is nearly universally approved of and hailed as a key element of a healthy market. Furthermore, it is often lauded as a risk-free trading type—and while it isn’t truly riskless it certainly has several key and unique advantages over many other strategies. 🤓

While the phrase arbitrage trading probably doesn’t mean much to most people—and comes from the Latin word for a judge to make it even scarier—it is far from hostile, and the only judgments you’ll have to learn to make are judgment calls.

So, without further ado, let’s dive into demystifying this important part of the market, and learn what makes it low-risk, but certainly not riskless.

What is Arbitrage Trading? 📚

Arbitrage trading is a short-term trading strategy that can be used on any kind of security—stocks, forex, crypto, and various derivatives—as long as there is an opportunity for the prices to diverge. An arbitrage trading opportunity is created when asset prices between markets stop being aligned.

While these differences can be significant, they are most commonly fairly slim—meaning that a trader often has to move a large number of securities to make a meaningful profit. 

The primary reason why most arbitrage opportunities consist of small price differences is that any larger divergence in value is likely to attract a larger number of traders. This increase in interest quickly corrects the values, thus completely shutting down the arbitrage opportunity.

Opportunities with slimmer profit margins have created some interesting tools a trader can use. Flash loans are pretty much tailor-made for arbitrage trading as they consist of borrowing money and repaying it within a few seconds—enabling the short-term debtor to leverage their trade and buy and sell a lot more securities than they otherwise could.

Trading Conditions 📃

In its purest sense, an arbitrage is executed solely when there is no market risk involved—meaning that the purchase and the sale are executed simultaneously, thus reducing market exposure to zero.

This makes only electronically performed stock market trades real arbitrage, however, this definition is expanded a bit in practical terms. A classic example of arbitrage would be a trader buying a product in one area at a lower price, and then moving to another place to sell.

Historically, a common example of arbitrage trading would be a merchant purchasing foodstuffs like grain in the countryside and transporting it to an urban area to sell. This, however, isn’t simple arbitrage in the modern sense as the merchant is exposed to various risks while traveling, and is liable to pay transportation fees, upkeep, and similar expenses thus reducing his overall gains.

No matter how strictly the definition is followed, there are three key conditions that have to be met for any arbitrage to occur:

• ☑ The same asset is traded in different markets at different prices;
• ☑ Two identical cash flow assets are traded at different prices;
• ☑ Or an asset with a known future price does not sell today at that known future price that has been discounted at a risk-free interest rate. In the sense of our traveling merchant that discount would account for the high potential storage costs of his purchased grain.

Understanding How Arbitrage Works 👨‍🏫

Arbitrage trading is one of those “easy to learn, hard to master” techniques. In a nutshell, it is as simple as seeing that shares of a company are trading at $9 in New York and $10 in Shanghai, then buying those shares in New York and selling them in China.

Arbitrage opportunities arise for many reasons and are generally a result of markets not being perfectly efficient—asset values don’t always accurately represent reality. These occurrences can also be taken advantage of with cryptocurrencies. 

Most major cryptos are traded on multiple platforms, and due to the consensus-based way these exchanges are determined—and the notable differences in volume between platforms—it is often possible to find significant price differences between markets. 

For example, news of a stablecoin like TerraUSD dropping significantly from its benchmark can create great opportunities for arbitrage trading before the prices and their movements stabilize.

Furthermore, it is possible to take advantage of exchange-rate discrepancies when trading forex. Essentially, it is possible – under the right conditions – to exchange U.S. dollars (USD) to Yuan (CNY), then Yuan to Yen (JPY) before finally changing Yen back to U.S. dollars for a small profit. However, this also highlights one of the issues with arbitrage trading—its potential for extraordinary complexity.

In recent years, arbitrage trading has been increasingly computerized—established investors tend to use algorithms to find the best opportunities as soon as they arise and capitalize on them just as quickly. Still, it is possible to find success in arbitrage trading without investing millions in tech—but first, you need to know what kinds of arbitrage exist, and what their quirks are.

Different Types of Arbitrage Trading 🗃

Since arbitrage trading can be done with different types of assets, this means there are multiple types of trades. These tend to vary significantly in both risk and complexity, and understanding them and choosing the right ones can be the difference between serious losses and major gains.

Simple Arbitrage 🧐

Simple arbitrage is—well—the simplest form of arbitrage trading. It is the closest type of all to the most basic definition of arbitrage trading and entails buying assets in one market and selling them in another at a higher price.

Considering the breakneck speed of modern algorithm-driven trading, most simple arbitrage is done within seconds and can be considered relatively riskless. This is, simply, due to the fact you aren’t trading based on assumptions, but on current facts.

Still, this doesn’t mean that nothing can go wrong. When it comes to traditional securities, hiccups, and glitches—like the ones that can cause a flash crash—can occur, preventing your trade from being executed at the desired price. 

Things can go wrong with crypto as well. While some of the potential problems can also arise from technical issues and errors, the somewhat bizarre nature of consensus protocols that many cryptos rely on may sabotage your arbitrage.

Lastly, the fact that most simple arbitrages occur within seconds, doesn’t mean that all of them do. By employing a tool like technical analysis, you might find that an asset is not realistically valued and enter a position that will allow you to capitalize on a simple arbitrage a while down the line. Even though these slightly longer-term trades tend to happen fairly quickly, they are based on predictions rather than current facts and are therefore liable to errors.

Retail Arbitrage 👴

Retail arbitrage can be seen as the grandfather of all other arbitrage forms. In a nutshell, imagine a famous brand making a deal with a famous athlete to release limited edition sneakers. 

These sneakers would be pretty pricey to begin with but also likely to increase in value due to being exclusive. A trader might want to make a profit with retail arbitrage by buying those sneakers now for $500 and selling them for $1000 when they are out of stock in official stores.

The same obviously applies to stocks. A promising company might announce it is finally going public prompting a trader to buy shares immediately while they are still essentially penny stocks and hoping they will soon skyrocket. Obviously, you aren’t limited to completely new shares. Various news might entice an investor to buy quickly hoping for hefty gains.

It is important to remember that some gold is in fact fool’s gold. Think of the recent news about Elon Musk acquiring Twitter. This might have appeared as a great retail arbitrage opportunity but by late May things had apparently turned sour  – so much so that the entire deal became uncertain. In fact, Twitter’s shares have hit such a low that they’ve essentially wiped all recent gains.

Merger Arbitrage 🏢

The case of the Twitter acquisition is relevant for another type of arbitrage trading—merger arbitrage. Merger arbitrage is generally considered riskier as—unlike simple arbitrage—it tends to take longer to complete. 

As we’ve outlined in the previous section, the basic idea of a merger arbitrage is to purchase shares of a company due for acquisition hoping their value will increase with the new owner.

However, since corporate mergers can fail either because the involved parties fail to reach an agreement, or because the government blocks them, it is possible to ultimately lose a lot of money attempting such a trade. 

The risk of such a strategy is increased even further because even if successful, mergers can take a while to complete—locking money in stocks that can go either way. Once again, the case of Musk and Twitter highlights the dangers of trying to leverage a merger.

Convertible Arbitrage ♻

To understand convertible arbitrage, you first have to understand convertible bonds—which is thankfully super-simple. In a nutshell, convertible bonds represent corporate debt that can be exchanged for the company’s shares. These securities are usually issued because they can come with a lower yield as the holder can get the associated stocks at a discount.

Usually, a prospecting convertible arbitrage trader would seek to combine taking a long and a short position. The basic idea is that they would take a short position on the stock, and a long one on the bond if the debt is considered to be cheap and vice-versa. The ratio between buying and selling assets in convertible arbitrage will also depend on how fairly the bond is priced.

Just like with other types of arbitrage, the trader would seek to take advantage of the differences and inefficiencies between the bond’s price, and that of the associated stock. The goal is, in most cases, to get the bonds cheap, and sell the stocks at a high price.

Triangular Arbitrage 📐

Triangular arbitrage is reserved for those utilizing complex strategies in the world of forex. For the uninitiated, forex trading involves trying to earn from the exchange rates between pairs of currencies. Triangular arbitrage follows the basic pattern we’ve seen so far but adds an extra step—and a layer of complexity.

Basically, those that want to do triangular arbitrage would need to find three pairs of currencies that would enable them to make a profit by exchanging currency A back into currency A. While this might appear confusing, it is fairly simple. For example, a trader would find that if they converted dollars to euros, and then euros to pounds, and, finally, pounds into dollars, they’d end up with a profit due to rate discrepancies.

While figuring out if these steps would return a profit for any given currency could be as simple as leveraging the tools and research capacity offered by the top platforms for forex trading, the trick is finding the right fiats. Since opportunities to earn through triangle arbitrage are often ephemeral, and there are 180 recognized currencies, you’d usually need a significant amount of computing power or—or a lot of luck.

Furthermore, the profit margins are often very slim. They can go as low as fractions of a cent and are seldom as high as several full cents. You’d need to move a lot of money through the trades to make a worthwhile gain.

Statistical Arbitrage 📊

Statistical arbitrage is all about finding pairs. These can be pairs of currencies, stocks, commodities, or anything else as long as they tend to move together on the market. This doesn’t mean that their prices are necessarily close to each other— say, PepsiCo could be worth $5 and Coca-Cola Co $1000—the important bit is that if one falls by about 15% so does the other, and if PepsiCo rises by 5%, Coca-Cola Co follows.

You’ll often find these pairs within shares belonging to the same industry. Think Ford and GM, or British Petrol and Shell. A good place to look for these correlations is also among various cyclical stocks. Furthermore, many currencies tend to closely align—this can happen when currencies are competing with one another, or when they are pegged together.

For example, the Moroccan dirham, Croatian kuna, and Bosnia & Herzegovina convertible mark are some of the currencies pegged to the euro.

To successfully conduct statistical arbitrage, you’d try and find divergences within common pairs. Any deviations from the usual pattern indicate a change is coming and a trader would seek to short the stocks of the firm on the rise and outright buy the shares of the declining company.

The idea is not to make a directional bet, but to make a profit once the prices converge and resume their usual pattern. Obviously, finding genuine pairs at the perfect time takes quite a bit of know-how, and leveraging the leading stock analysis tools can save any trader a lot of headaches resulting from a bad bet. 

Arbitrage Trading Strategies 📜

Since there are multiple types of arbitrage, it is no surprise that there are many strategies a trader can pursue. These will radically differ between assets being traded and can have a multitude of variations based on the exact context, but there are several that remain relative staples of the practice.

Risk Arbitrage 💶

Risk arbitrage strategy is closely associated with merger arbitrage trading—so much so that it happens almost exclusively in the context of mergers and corporate acquisitions. Essentially, once an agreement is reached, it becomes known what the share price of the acquired company will be after the deal comes through.

For example, a firm can be bought out at the price of $100 per share. On the other hand, the current price of the stock is $95. This means that an investor choosing to buy today can expect a profit of $5 per share once the merger is complete.

However, the fact that there is an agreement between the two companies offers no true guarantees. Often, there are numerous kinks that have to be ironed out between the time when the deal is struck, and when the merger actually materializes.

Furthermore, the government has the authority to block a merger of two corporations under certain conditions—and this process isn’t automatic so it is impossible to have a checklist that will accurately tell you if Uncle Sam will pull the plug on the acquisition. Lastly, even if the authorities greenlight the deal and the kinks are ironed out, one party or the other might stall the merger or back out altogether.

Additionally, even if everything goes as planned, it is still possible for the entire thing to turn out to be an unmitigated disaster—like what happened with the world-infamous AOL merger with Time Warner. Fortunately, the disaster would have to not only be immense but also nearly instantaneous for it to affect a trader seeking to sell as soon as possible.

All these factors constitute risks of a merger arbitrage—and therefore give the strategy its name. As with nearly all risky investment tactics, it is possible to hedge against the losses by shorting the stocks of the acquiring company, or getting put options on the company being bought—however, unless executed perfectly, hedging has a tendency of nullifying most of the gains if the initial bet truly was a winning one.

Fixed Income Arbitrage 💵

Fixed-income arbitrage mostly deals with fixed-income securities—bonds and dividend stocks. The end goal is to profit from interest rates—or rather from the inefficiencies in how they are valued. For example, an investor might find two bonds from two different yet very similar issuers.

The bonds have different interest rates but the issuers are nearly identical—they have a similar track record, boast similar performance, and have similar potential. Therefore, the investor might believe that the interest rates should be equal and can trade accordingly. They can short the bonds with the higher rate, and enter a long position on the undervalued ones.

This way, they aren’t really making an exact directional bet. It doesn’t matter where the prices precisely end up. The only important thing is that they become as close to the same as possible. Say that bond A has a rate of 2%, and bond B is 1.5%. It doesn’t ultimately matter if they both end up at 3%, 4%, or 0.5%, the only thing that matters is that they come to the same level.

This strategy is somewhat similar to statistical arbitrage as it also seeks out pairs that should have a similar value and tries to capitalize on their unjustified divergence. Also, similarly, if done correctly, it doesn’t matter where exactly the values equalize as long as they do come to the same level.

Still, this surface-level simplicity doesn’t mean that fixed income arbitrage should be taken lightly. As any student of mosaic theory will know, there are numerous factors that can determine the future direction of an asset. Doing proper analysis and knowing where to look can help you ensure you really are onto something and aren’t simply giving into wishful thinking.

Covered Interest Arbitrage 💷

Covered interest arbitrage deals with forex. This strategy aims to exploit the difference between currency exchange rates in different countries. This is achieved through futures and the forward market which attempts to account for changing interest rates on various currencies, and the trader profits if that calculation isn’t accurately done.

The less complicated cousin of covered interest arbitrage is the so-called uncovered interest arbitrage. This other type avoids dealing with futures altogether and simply entails borrowing a lower rate currency and buying the higher rate one. 

The uncovered approach works only if the higher-value currency doesn’t drop more than the difference in the value of interest rates. If this happens, the trader will lose money attempting this strategy. This happens as ultimately the borrowed currency has to be returned—and therefore the trader must ultimately convert it back into the lower value currency. If the price difference shrank too much, money is lost.

A Practical Example of Arbitrage Trading 📝

If you’ve ever been on the Las Vegas Strip, you know there are people walking around selling 17 OZ water bottles to thirsty tourists for $1 a piece. These same bottles are sold at Walmart in six-packs for $2.5. This is a very clear example of typical retail arbitrage trading as those people are buying where it is cheap, and selling where it is pricey.

You can find this principle nearly everywhere. Restaurants and bars buy food and drinks in large quantities and sell them to patrons at significant markups—at a price 5 or more times higher usually. A similar logic applies to soft drinks. The price per ounce of canned Coke is noticeably higher than for a large bottle.

This very basic idea of arbitrage trading was even used by a young Warren Buffet when he—much like the vendors of Las Vegas—noticed he could buy six packs of water and sell the bottles individually at a slightly higher price.

Arbitrage trading functions in much the same way with stocks and other assets. You can, obviously, mix and match tactics and instruments to maximize your gains, often jumping through several hoops to earn some money.

To keep things simple, say that shares of company X are trading for $40 in New York, and for 50 AUD in Australia with the exchange rate giving you 44 AUD for $40. An investor might purchase $80 of shares in NY and sell them in the land down under pocketing 12 AUD, or $10.9.

Pros and Cons to Consider ⚖

While arbitrage appears safe and simple at first glance, the reality often isn’t quite so amazing. While basic arbitrage trading is theoretically risk-free—you don’t need to be able to see the future to do it right, you just have to be attentive—unexpected market exposure often occurs.

A large number of trades occurring simultaneously—which is pretty much all the time in the modern automated market —can stagger trades making them execute seconds or even minutes later than desired. Since arbitrage opportunities tend to start and end very quickly, these seconds can often be the difference between earning and losing.

Additionally—like most other types of trading—arbitrage is liable to self-sabotage. Shoddy research, impulsiveness, and poor self-control can lead a trader down the path of many mistakes and ultimately result in huge losses and even bankruptcy.

On the other hand, when executed properly—both on the human and computer side of things—arbitrage trading can be very good to make a decent amount of money without being exposed to unbearable amounts of risk.

Another issue with arbitrage trading is that it is so reliant on machines to identify and execute trades at the right moment. This can make entering the competition troublesome for individual investors who have neither the know-how nor the equipment to survive in a very fast-paced environment.

A dramatic example of how arbitrage trading can fail even with otherwise low-risk securities like bonds came in the late 90s when a heavily leveraged hedge fund Long-Term Capital Management made a bet that Italian and U.S. instruments should have their interest rates equalized.

Unfortunately for the fund, they made their bet around the same time as the Russian government defaulted on its bonds and Asia faced a financial crisis leading trust in foreign instruments to plummet. The subsequent change of public sentiment caused the interest divide to widen, ultimately losing the fund billions.

Fortunately for the fund, it was considered too big and interconnected to fail, leading to a huge government bailout. Unfortunately for an individual traded that might find themselves in similarly dire straits, they are probably not too big to fail.

Arbitrage in Forex 💱

In many ways, the forex market seems tailor-made for arbitrage. It is large, very liquid, global, and decentralized. These factors make pricing discrepancies very likely to arise—bringing arbitrage opportunities with them—and they ensure most orders are executed as soon as they are placed.

On the other hand, the size and speed of forex create a relatively high barrier to entry for any individual. While knowing where to look for winning trades is half the battle, actually finding them and capitalizing is a whole other story.

A trader wishing to succeed with this type of arbitrage will need access to real-time price updates, reliable analysis software, and the infrastructure needed to take advantage of the many short-lived windows of opportunity.

Furthermore, while there is no shortage of forex brokers, scams are fairly commonplace. Thousands upon thousands of dollars every week are often promised while the actual performance is something completely different.

None of this should discourage anyone curious to dabble in forex arbitrage. The market genuinely creates constant opportunities for the agile and the skilled, and despite the scams, reputable and reliable brokers for total forex novices, are abundant.

Crypto Arbitrage Trading 🪙

Much like the foreign exchange market, the cryptocurrency platforms are generally ripe for arbitrage trading. Since every large marketplace for crypto—be it Coindesk, Coinbase, Kraken, or some other—is in a way a self-contained space, current bid and ask prices can vary widely between them.

This makes genuine arbitrage—the one where the purchase and sale happen almost simultaneously—fairly easy to achieve. Everything a trader needs to do is find two marketplaces with satisfactorily different bids and asks, buy cheap, and sell at a premium.

Relatively wild price swings cryptocurrencies sometimes suffer from can actually be a strength for an arbitrage trader. They make volume less of an issue as a lower investment can generate significant returns compared to forex and stocks.

The basic strategies for crypto arbitrage are much the same as with other securities. The idea remains to buy the asset in a cheap market and sell it where it is expensive. In the world of crypto, this can be done locally—in the so-called cross-exchange arbitrage—or in various different regions when doing spatial arbitrage.

Furthermore, considering the number of currencies available, triangle trading is certainly possible with various cryptocurrencies—and can be done by mixing crypto and other assets. If you find a way to convert Btc to Djiboutian francs and then to Eth and make a killing while doing it there is nothing really stopping you.

Additionally, with the arrival of Bitcoin ETFs in many parts of the world, the world of crypto arbitrage might become even more interesting. Cryptocurrencies are likewise conducive to statistical arbitrage and can be traded on decentralized and automated markets—which sometimes make price differences even more pronounced.

What Makes Crypto Arbitrage a Low-Risk Strategy? 🤔

Generally, arbitrage is a much lower risk type of trading than most others. This is generally because a prospecting investor doesn’t need to have a crystal ball or a sixth sense to figure out which trades they should make. Their job boils down to finding the current price discrepancies and having the reflexes to take advantage of these divergences.

This, however, shouldn’t lead to overconfidence as low risk isn’t the same as no risk. Apart from the obvious—misidentifying an opportunity, or failing to execute the trade in a timely fashion—there are less noticeable dangers. While death tends not to involve itself, taxes—and other fees—are an ever-present concern for anyone not intending to hold onto a security for a very long time.

Indeed, while short-term capital gains taxes are punishing, fees can be even more insidious and exorbitant, even nullifying all the gains achieved through trading. This can happen to any trader even if they never become a victim of a scam promising rags-to-riches while actually simply milking the customers dry.

Another concern when arbitrage trading crypto is wallet security. Essentially, cryptocurrency wallets are hackable and can be stolen from—and since most traders are likely to have a lot of money in those wallets, keeping a tight ship and being mindful of security is very important. To be fair to arbitrage trading, wallet security is a priority whatever your dealings with crypto are—short, mid, and long-term.

Conclusion 🏁

Arbitrage trading is in its essence, a simple concept with a scary name. In many ways, it represents the most low-risk strategy for an impetuous trader to make money relatively quickly. On the other hand, it is possible to say that the greatest weakness of arbitrage is that it is so often touted as riskless—leading traders to be far more reckless than they should.

Still, it is important to remember that some bigger concerns do exist. Since the profit margins tend to be so small, the size of the needed investments can often be prohibitively large—or it can force a trader to take an uncomfortably large loan. Furthermore—and going hand-in-hand with the problem of recklessness—it is important to remember that most fast-paced trades are conducted by high-speed computers forcing nearly everyone who wants to profit to come prepared for a lightning campaign.

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