Arbitrage Strategies

In theory, arbitrage is a riskless profit: buying something in one place and selling the same thing at a higher price elsewhere at the same moment. In practice, almost every arbitrage strategy carries some risk, whether from timing, costs, financing or the chance that prices diverge further before converging. The basic concept is in the Arbitrage lesson; this lesson walks through the main strategies traders actually use and where their risks lie.

Pure vs risk arbitrage#

Main arbitrage strategies#

Spatial or exchange arbitrage#

Buying an asset on one exchange and selling it on another where the price is higher. Common in crypto, where prices on different exchanges can differ, especially in stressed moments. Risks include transfer delays, withdrawal limits, fees and exchange failure. See Centralized vs Decentralized Exchanges.

Cash and carry arbitrage#

Buying the underlying asset and selling a futures contract when the futures price exceeds the spot price by more than the cost of carry (financing and storage). The position is held to expiry, when the prices converge. See Cash-and-Carry Arbitrage and Basis and Basis Trading.

Funding rate and basis arbitrage in crypto#

Holding spot crypto and shorting a perpetual future to collect funding payments when funding is positive. See Funding and Basis Arbitrage and Funding Rates.

ETF arbitrage#

Authorised participants create or redeem ETF shares when the ETF price drifts from the value of its holdings, keeping the ETF close to fair value. See What Is an ETF?.

Options parity arbitrage#

Put call parity links the prices of calls, puts, the underlying and interest rates. If they get out of line, traders can build offsetting positions to capture the difference. See Put-Call Parity.

Merger arbitrage#

After a takeover is announced, the target's shares usually trade below the offer price. Merger arbitrageurs buy the target (and, in stock deals, short the acquirer) to capture the gap if the deal closes. See Mergers and Acquisitions.

Statistical arbitrage#

Trading many related securities based on statistical relationships rather than exact equivalence. See Statistical Arbitrage.

Why arbitrage is never fully riskless#

• Execution risk: prices move before all legs are filled.
• Costs: fees, spreads and taxes can exceed the gap. See All-In Trading Cost.
• Financing risk: borrowing costs change, or lenders demand more margin.
• Divergence risk: the gap can widen before it closes, forcing exits at a loss. This sank Long Term Capital Management in 1998. See The Collapse of LTCM.
• Counterparty and platform risk: an exchange or broker can fail. See Market, Credit and Counterparty Risk.
• Event risk: deals can collapse and regulations can change.

Who does arbitrage#

Most simple arbitrage is captured by firms with fast technology and low costs, so gaps close within milliseconds. Opportunities that remain for individuals tend to carry real risk or require patience and capital, such as merger spreads or basis trades.

Frequently asked questions#

What is an arbitrage strategy?#

A strategy that tries to profit from price differences between identical or closely linked assets, usually by buying one and selling the other.

Is arbitrage risk free?#

Rarely in practice. Execution, costs, financing, divergence and counterparty risks mean most arbitrage carries some risk.

What is merger arbitrage?#

Buying the shares of a company being acquired below the offer price, betting that the deal will close and the gap will be paid out.

Next, learn how traders earn income by holding higher yielding assets in Carry Trading.