What Is Arbitrage?
Arbitrage describes the act of buying a security in one market and simultaneously selling it in another market at a higher price, thereby enabling investors to profit from the temporary difference in cost per share.
Arbitrage is a widely used trading strategy and probably one of the oldest trading strategies to exist. Traders who engage in the strategy are called arbitrageurs.
Let me tell you a story about a “Chaiwala”! He was truly chaalu or shall we say, “Extra Smart”!! He would provide tea at ₹ 5 per cup and his cost of preparing the same was ₹ 4. Thus, he made a profit of ₹ 1. But he was not happy with making a profit of just ₹ 1. So he thought about how he could increase his profit.
It was then that he had a brainwave out of the blue! He identified a Government canteen which offered tea at ₹ 2. BIG IDEA! Wasn’t it? He could now simply buy tea for ₹ 2 and sell it for ₹ 5 and make a much better gain of ₹ 3! This buying of a thing in one market and selling in another market at a higher price is known as “Arbitrage”.
Similarly, if arbitrage opportunities exist, stocks too can be purchased in one market at a lower cost and sold in another at a higher cost.
So, for the next few days, our Chaiwala had a field day earning happily as he served his daily chai.
But Alas! Such arbitrage opportunities do not last long. As information flow increases and the arbitrage opportunity gets known, it soon starts to disappear. And this is exactly what happened in the case of our “chaiwala”.
The chaiwala had an assistant who one day spilled the beans about the “arbitrage” advantage being enjoyed by the chaiwala. Soon after that, the chaiwala was rounded up and he confessed about the arbitrage opportunity he had spotted.
Since his customers, in a sense, had been paying a fair price all this while since ₹ 5 had been the standard retail price in all canteens, the chaiwala was forgiven but was warned against adopting this practice again.
So, the arbitrage opportunity too vanished in thin air as the very next day, he was back in his own canteen making tea at ₹ 4 and selling it at ₹ 5.
Thus, it’s important to understand that “arbitrage” opportunities are short-lived. It is essentially a short window of opportunity that can be exploited by taking action at the right time. As information flow gets efficient, this opportunity vanishes as we saw in the case of the chaiwala.
- Arbitrage occurs when a security is purchased in one market and simultaneously sold in another market, for a higher price.
- The temporary price difference of the same asset between the two markets lets traders lock in profits.
- Traders frequently attempt to exploit the arbitrage opportunity by buying a stock on a foreign exchange where the share price hasn’t yet been adjusted for the fluctuating exchange rate.
- An arbitrage trade is considered to be a relatively low-risk exercise.