Arbitrage

Arbitrage is buying something in one place and simultaneously selling the same thing, or its equivalent, somewhere else at a higher price, locking in the difference. In its pure form, it is a profit with no exposure to price moves, because the buy and sell offset each other. In reality, pure arbitrage is rare and fleeting, and most strategies called arbitrage carry some risk.

A simple example#

That last point is the key to arbitrage: it is self correcting. Every trader who exploits a gap helps close it. This is one of the main forces that keeps prices for the same asset aligned across markets. See Price Discovery.

Types of arbitrage#

Only the first few are close to risk free. Merger and statistical arbitrage are really bets that a relationship will hold.

Why pure arbitrage is so hard to find#

• Speed: professional firms with fast connections and automated systems close obvious gaps in milliseconds.
• Costs: spreads, commissions, transfer fees and taxes often exceed the gap.
• Capital: you usually need funds on both sides of the trade at the same time.
• Size: gaps are often small and only available for small quantities before prices adjust.

The hidden risks in "risk free" trades#

1. Execution risk. You fill one side but not the other, leaving you with an unhedged position.
2. Transfer risk. Moving assets between venues takes time, during which prices move or withdrawals are paused.
3. Counterparty risk. An exchange or broker on one side fails or freezes funds.
4. Deal risk. In merger arbitrage, the deal can collapse and the target's price can fall sharply.
5. Convergence risk. Prices that "should" come together can drift further apart before they do, forcing a trader with leverage to close at a loss. The collapse of Long-Term Capital Management in 1998 is the famous example. See The Collapse of LTCM.

Why arbitrage matters to every trader#

Even if you never run an arbitrage strategy, arbitrageurs shape the prices you see. They keep ETF prices near their holdings, futures near fair value, the same coin priced similarly across major exchanges and currency crosses consistent. When those links break, often during market stress, it is a sign of something unusual: frozen withdrawals, a liquidity crunch or a broken market.

Frequently asked questions#

Is arbitrage legal?#

Yes. Arbitrage is legal and helps keep markets efficient, though specific practices such as front running client orders are not arbitrage and are illegal.

Can retail traders do arbitrage?#

Occasionally, especially in less efficient markets like smaller crypto exchanges or prediction markets, but costs, transfer delays and competition make reliable profits difficult.

Is arbitrage really risk free?#

Pure arbitrage is close to risk free in theory, but in practice execution, transfer, counterparty and convergence risks mean most real arbitrage involves some risk.

Sources#

• Wikipedia, Arbitrage