What is Arbitrage?

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Richard Gere starred in the movie Arbitrage. It is one hell of a movie, a great thriller, it is all about money and about high finance, a Vanity Fair story come to life.

But what is Arbitrage? According to investopedia:  “The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time.”

There are two types of arbitrage: pure arbitrage and risk arbitrage. The former is said to be risk free and the latter is speculative as it is based on projection on future events.

Let’s look at an example of pure arbitrage. If a commodity is currently trading on the spot market at a particular price and simultaneously a futures contract suddenly becomes cheaper, then someone familiar with arbitrage can short the more expensive spot commodity and buy the cheaper futures contract and profit from the difference.

Retail traders would not have the resources (fast computerised systems) to benefit from this short term difference.

Remember that Arbitrage and Speculation are very different strategies. So from the example given above, Arbitrageurs who have fast computerised systems may do the simultaneous trading without taking risk.

Speculation on the other end of the spectrum is a type of a financial strategy that involves Risk. I put Risk in capital R because it is dangerous. Speculators attempt to profit from rising or falling prices. A trader, for example, may open a long (buy) position in a stock index futures contract with the expectation of profiting from rising prices. If the value of the index rises, the trader may close the trade for a profit. Conversely, if the value of the index falls, the trade might be closed for a loss.

Speculators may also attempt to profit from a falling market by shorting (selling short, or simply “selling”) the instrument. If prices drop, the position will be profitable. If prices rise, however, the trade may be closed at a loss.

At FS Securities, we always speculate on outcomes in the market.  However, of recent times we decided to take strategies that make profit irrespective whether the market goes up or down.

More tomorrow about these fascinating strategies.  We are aware they are not for everyone.