The term market arbitrage is used to refer to that activity in which the buying and the selling of the same type of security are done and that too at the same point of time but in two different markets.
Now, this security can be anything it can be bonds, shares, currencies, etc. This type of activity is performed in order to gain the benefits of the price difference between them.
Understanding the concept of Market Arbitrage
Market arbitrage is an activity which focuses on the buying and selling of the securities take place. Market arbitrage is a smart trading strategy the primary purpose of which is gain financial benefits.
In Market arbitrage generally, there is a trader, who would at first sell particular security that he is having with him already in any one specific market and the immediately after this, he would purchase the same type of security in one another market. This way he would be able to gain the financial benefits due to the price difference in both the two different kinds of market.
Now the trader is free to trade with the type of security that he wants to. If he wasn’t to trade with currency, he is free to do that, if he wants to trade with gold he can do that as well. They’re not a set of rules or limitation n a trader for the types of security he wants to buy or sell.
He can trade with any security be it currencies, gold, securities, bonds, shares or any other valuable assets that have a price value in the market. Now market arbitrage is a smart financial strategy that ensures success to the majority of the times for the traders.
Now to carry market arbitrage effectively, there are a few things that one should keep in mind before going ahead with it.
The first thing is that to gain the maximum benefits one need to do both the buying and selling in close proximity of time. Also, it should be two different markets having two different pricing standards.
Along with that, the security that is being traded should also remain the same when it is being bought and sold in the two different markets.
Now since in market arbitrage it depends upon the trader as to what kind of securities does he want to trade or in which market he wants to buy or sell the securities, he is free to take calculated risks?
He gets full liability to analyze market first and only then of ahead with the trading. This way they can improve their chance of success and eliminate the chances of risks or failures. Therefore this trading stagey is generally considered to be quite a risk-free profit for the traders or the investors whoever is involved.
Also, the main reason for the rise of market arbitrage is the flow of the asymmetric information between both the buyer and the seller.
How does Market arbitrage work?
So in general in market arbitrage, the trader or the investor would try to short sell the stock of the higher prices and then by the similar one at a low price at almost the same point of time. And in this way, he or she would be able to gain a fair amount of profit.
Here the profit that is gained is generally the difference that is obtained between the two different assets that were initially sold and bought from two different markets at almost the same point of time.
Thus in market arbitrage generally that particular asset is traded which can have different pricing in different markets spread all over the world. This would mean that the same stock will have a different market value in the New York Stock Exchange (NYSE) in the US and then that same stock would have a different market value in some other county say Japan.
Now market arbitrage is generally considered to be an utterly riskless activity, and thus more and more traders and investors look forward to investing in it. Theoretically, it has been said that, for market arbitrage to take place, it is quite necessary that the price value of the similar kind of security which is being traded has to be the same or equal to another in the two different markets.
Now that market arbitrage is a completely riskless activity which involves simply the buying and the selling of the products having an equal amount at the same time but in two different markets, it is also referred to as the ‘riskless profit’.
Examples of market arbitrage
Now to understand market assets is no difficult job. It is simply the buying and the selling of a similar kind of financial security in two different markets at the same point of time. Also to carry on with the practice of market arbitrage, it is assumed that market value of that particular asset is different all across the world.
For instance, the same stock which the trader or the investor will be selling in Europe will have a different prices value as compared to when that same trader or the investor will be buying the same kind of assets in the US.
Now two understand market arbitrage in a more clear let us took a look at few of the example-
For instance, there is a company say ABC. Now the stock trades are at say $7.00 per share in the NYSE which stands for the New York Stock Exchange. And the same stock is at $7.07 on the LSE which stands for the London stock exchange.
Now here it can be seen that for the similar kind of stocks how market value can be different. Now what the trader can do here is that he would buy the stock from NYSE at $7.00 on the NYSE and then he would go on to selling it at $ 7.07 at the LSE. This way he will be making a profit of $0.07 per share. Now here the $0.07 profit that he makes is only on one share.
But when the arbitrageur will be making many share purchases, by the end of this whole market arbitrage activity, he would have already gained a lot of money. And this is precisely how the traders make money from market arbitrage.
Now when it comes to the stock markets, the traders or the investors who are namely called the arbitrageur generally tend to exploit the opportunities that they get in market arbitrage. To understand this let us consider one another example.
Suppose that there is a trader who is thinking of buying a stock on the foreign exchange. Now suppose that the stock that he is willing to buy, its price value has yet not been adjusted at a fixed point.
And the exchange rate keeps fluctuating constantly. Thus here the stock price that is there on the foreign exchange is heavily undervalued when it is compared with the price that was there on the local exchange.
This way there will be a vast difference between the prices of both the tow stocks although they are of a similar kind. And here the trader will be easily able to make a lot of profit from the difference in the prices of the stocks.
The practice of Market Arbitrage trading system. is it riskless?
Now even if market arbitrage is often termed as the riskless profit because it appears like that, but this is just the story on the surface. When going deeper into the matter, there are certain risks associated with market arbitrage. There are a whole lot of risks associated with market arbitrage.
For instance, there is quite a lot of risk associated with the price of the security that is being traded in terms of offset marketing. And there may also be the case in which it may rise up unexpectedly thus resulting in a loss for the trader or the arbitrageur.
Also theoretically it has been said that market arbitrage is a type of a short-lived opportunity because in this prices of the security are adjusted on their own depending upon the forces of both the supply and the demand.
Now to make a significant amount of profit from market arbitrage, it is necessary that there is a good amount of capital. Thus in the majority of the cases, it has been found that majorly the intuitional investors and the hedge funds are those which are able to make a lot of profit out of it.
Thus due to the requirement of a significant amount of capital, generally it is not considered to be quite suitable for the individual who does not have enough of the capital.
Thus market arbitrage is an excellent strategy in terms of trading which is usually known to benefit many of the big financial institutions and the organizations.