What is arbitrage in Trading: Examples and How It Works

How to start earning on arbitrage between exchanges and instruments—the essence of arbitrage trading and transactions, types and examples of strategies. First of all, what is arbitrage?

The essence of arbitrage is to obtain risk-free/almost risk-free profit. In classical trading, the trader predicts the behavior of the asset and opens long or short positions accordingly. Arbitrage strategies, in contrast to the classical approach, are aimed at generating profits regardless of the chart direction.

Arbitrage on the exchange can bring income but it is a very specific trading tactics and is not suitable for all traders. Below is a detailed explanation of this technique and an overview of its variants.

What is arbitrage in simple words

In simple words, arbitrage is a low-risk trading technique in which a trader makes a profit regardless of the direction of the price movement. Profit is generated by the divergence of prices for the same asset on different trading floors. This is just one of the subspecies of this tactic, various modifications use derivatives (futures and options) as well as the time factor.

Arbitrage is always a relatively small profit, in trading there is always a direct correlation between the level of risk and profitability. In this tactic, the risk is reduced to a minimum, which affects the size of the profit.

This approach is not a ready-made strategy, but rather an idea, a foundation, on the basis of which both manual and automated trading systems are created. The main difficulty in developing a TS is the algorithm for selecting assets for arbitrage, and automating the opening and closing of positions. Market inefficiencies usually disappear quickly, and it is not always possible to “catch” them manually.

The essence of arbitrage trading on exchanges

Traders found a way to make money on arbitrage – they used the idea of the difference in quotes of the same asset on different trading floors. The difference can be caused by a trivial lag in receiving quotes by one broker relative to another. It is possible to earn on this inefficiency by compensating the low income with big volumes.

With the appearance of such instruments as futures and options the possibilities of arbitrage widened. Modified methods appeared that used the underlying asset and derivatives on it. This approach is called long term arbitrage and such strategies can be traded in manual mode.

Regardless of the chosen asset and trading floors, interchange arbitrage comes down to the search for a significant divergence of quotes for the same asset or assets with high forward/backward correlation. It is possible to be limited to one platform, hedging the position on one asset by a synthetic asset on another. This and other approaches are discussed below.

Which assets are suitable for arbitrage

Not all tools are suitable for making money on arbitrage. For this methodology will be suitable:

  • Liquid stocks. Papers of 2 and 3 echelons are not suitable because their movements can be difficult to forecast, the probability of impulses is high. It is advisable that futures and options on shares are available, it will widen trader’s possibilities. It is possible to arbitrage on shares and depositary receipts or shares and futures on them.
  • Currency pairs. This tactic also works in Forex and there are several variants of its implementation.
  • Precious metals and commodity market instruments.
  • Cryptocurrencies. This type of assets was especially popular among arbitrageurs at the initial stage of the industry’s development.

Any asset that meets the following requirements is suitable for this technique:

  1. Sufficient liquidity and volatility. Low-volatility instruments have a lower probability of meaningful divergence of quotes on different exchanges.
    Availability on different exchanges.
  2. Availability of futures and options on the asset.
  3. This will allow the use of long-term market arbitrage, which uses the divergence of quotations of the underlying asset and the corresponding derivative.

There are no strict limitations on the selection of assets for this tactic. Usually they are limited to the most popular stocks, cryptocurrencies and currency pairs among the majors. The vast majority of strategies are automated.

Time arbitrage

The simplest version of this tactic is the one with which you can start learning arbitrage. The work is done on one exchange, possibly on one asset. High speed transactions are not necessary, the work can be done manually.

Futures, options, and simple asset purchases (stocks, currencies, cryptocurrencies) can be used for trading. This type of transactions is called temporary because the profit is derived from the price fluctuations of the underlying asset over a certain period of time.

An example of a strategy of this type is gaining profits by changing the price of a currency or an asset over time.

Spatial arbitrage

Arbitrage trading of this type is somewhat more complicated compared to time trading. The trader profits from the difference between the prices of the same asset on different trading floors. Work can also be carried out within the limits of one exchange, but then to the underlying asset, for example, shares of the company, futures on these securities are added. That is, when working within one exchange, two assets with a guaranteed high correlation are needed.

Depending on the implementation of spatial arbitrage, the following subspecies of this tactic are distinguished:

  • Equivalent, the second name of the spot futures. The underlying asset and its futures are taken as a pair of instruments.
  • Regulatory, this type of transaction is used, for example, by banks. Regulatory arbitrage gives legal entities an additional advantage through the regulatory features of related jurisdictions. For example, banks can set up affiliated microfinance institutions, evaluate clients, and decide where to refer clients depending on the level of risk. This style of trading is not available to ordinary traders.
  • Calendar spread. It is supposed to work with derivatives with different expiration dates. For example, a more expensive contract with a long expiration time is sold and a futures contract with a closer expiration time is bought. The expectation is that prices will level off over time.

For illustration, an example of equivalent spatial arbitrage is shown below. A pair of Lukoil shares and a corresponding futures is used. Trading is reduced to buying or selling a synthetic (artificial) bond.

When buying a synthetic, the trader buys the securities directly and sells the corresponding futures contract. It makes sense if the futures are in contango, i.e. traded more expensive than the stock. As the expiration date approaches the difference in price disappears. The meaning of this position is the same as in the case of money lending with the loan secured by securities.

The sale of the synthetic bond is justified in case of backwardation. That is, the futures should trade lower than the value of the corresponding stock.

The chart above shows that the total synthetic bond result is not constant and depends on changes in the value of the stock and the price of the futures contract. The following options are possible:

  1. The stock rises, but the futures do not change. The trader makes a profit by selling the securities, the position on the futures is closed by buying the same volume.
  2. Stocks and futures are going down. The loss on securities is offset by the rising yield on futures.
  3. You can wait for the contract to expire and still make a profit even if the futures price goes up. The negative variation margin will affect it, but the final result is likely to be positive. That is why arbitrage is useful in trading – the risks are greatly reduced and in most cases the trader is in the small profit.

Spatial arbitrage can be implemented in the form of both manual and automatic strategies.

Interest arbitrage

The most conservative strategy of work, involves benefiting from the difference in interest rates for different currencies. If working without forward coverage, the arbitrage transaction involves currency risks, forward coverage eliminates this risk.

Principle:

  • The investor has borrowed funds in euros, the rate for using the loan is 3%.
  • Dollars are purchased with the euros received.
  • Bought dollars are deposited at a rate of 2.8%. At the same time there is a sale of dollars.
  • The deposit brings 2.8% for the year, the forward contract another 0.4% per annum.
  • The repayment of the underlying loan will result in a net yield of 0.2%.

This scheme uses forward coverage (sale of the dollar), which neutralizes currency risks. A scheme without coverage is also possible, in which case the currency is simply placed on a bank deposit, and the investor risks losing some of the money in the event of unfavorable exchange rate fluctuations.

The profitability of this scheme is not high, during the period of low interest rates it can be about 0.2-0.4% per annum. The main advantage of this style of trading is the opportunity to get virtually risk-free income.

Spread trading

The spread refers to the difference between the prices. When trading the spread, the trader’s earnings do not depend on the movement of the quotations of the underlying asset in a certain direction, but on the maintenance/increase of the difference between the prices of two instruments. For example, such instruments can be stock futures or cryptocurrencies.

A classic example of working with the spread is the simultaneous buying/selling of futures contracts with different expirations. This technique is called calendar spread trading, the difference in value between contracts with different expirations.

The price difference tends to vary within a certain range, if you sell the more expensive far futures and buy the near futures, you can make money on the change in the spread between them.

Spread buy/sell is a synthetic position and always requires at least two trades:

  • Buying the spread means a long on a short futures contract and a short on a long futures contract.
  • Selling is a mirror position, selling a contract with a close expiration date and buying a contract with a long expiration date.

This is not an ideal strategy, the main risks are the possibility of GAP formation, slippage at high volatility. This scheme is also suitable for stock market instruments.

This scheme will also work for the Forex market, but spreads will have to be bought/sold according to a different principle. Below is an example of spread trading on EURUSD:

  • We open a long position on EURUSD, the volume is equal to, for example, € This operation corresponds to a long position on EURUSD. The EURUSD exchange rate is equal to 1.2134, this operation costs $121340.
  • The next step in the scheme is selling EURGBP or buying GBP for EUR – the meaning is the same. The EURGBP exchange rate is 0.8875 and £88750 is purchased for €100,000.
  • The next step is to short GBPUSD or to buy American dollars for British pounds. At the rate of 1.3700 $121587.50 is bought.
  • Euros are bought for dollars in order to return to the starting point. At the EURUSD rate of 1.2134 for $121587.50 it is possible to buy €100203.97.

This currency arbitrage brought a profit of €203.97. The result is not bad, but such differences in quotations are not always found, moreover, the profit is “eaten away” by the spread in trading, as well as by the commissions. Such differences are traded on Forex, if at all, only in automatic mode.

Features of arbitrage strategies

The features of this trading tactic include:

  • Possibility to work both within the limits of one platform, and on 2-3. Arbitrage between exchanges is actively used in the stock market. At the initial stage of computerization of Forex market the inter-broker arbitrage was used, because of the insufficient speed of obtaining the quotations the significant discrepancies of the prices were observed. By the end of the noughties of the 21st century this method became practically unviable.
  • Strategies can use both spot market instruments and futures/options. There is always a high correlation between the underlying asset and its futures, which allows strategies of this type.
  • Both aggressive high-intensity trading and long-term work with holding open positions for several weeks are possible.
  • Для этой методики подходят ликвидные активы, в том числе криптовалюты. Торговля, например, на акциях 2-3 эшелонов – не лучшая идея.
  • You can profit from price differences of the same asset on different trading floors, but you can also profit from price changes over time on the same exchange. Arbitrage is one of the most flexible trading techniques.
  • The ability to build a market-neutral strategy. It means that it is not necessary to correctly predict the behavior of the chart to make a profit. For example, when working with the calendar spread, it is enough to change the difference in the value of contracts with different expirations.

Arbitrage seems too complicated for beginners, but that’s a misleading impression. Trading does become a bit more complicated, but only because you have to make several trades instead of just one.

Automatic arbitrage

Automation is necessary not only to make work easier. The window of opportunity for trading may exist for only a few seconds, the trader will not physically be able to give orders to make trades. Advisors are the only way to use such opportunities to make money.

One of the scenarios in which manual work is not possible:

  • Bitcoin quotes are tracked on Binance, for example.
  • If the growth over a certain time interval exceeds the threshold value, then another exchange buys WMX tokens at a lower price. With the help of a robot it is possible to buy WMX tokens (secured by Bitcoin) at a lower price if orders have not yet been adjusted. It is impossible to work manually in this style.

There are separate services for finding market inefficiencies, for example, at apitrade.pro all popular exchanges are added, and trading is done in fully automatic mode. The idea of trading is significant divergence of cryptocurrency quotes on different exchanges, sometimes it happens due to increased volatility of crypto. There are similar services offering similar services.

In addition to online services, there are separate full-fledged robots for trading terminals. For example, there are bots for QUIK that can search for price discrepancies for a number of instruments, evaluate trading opportunities using indicators, and take market conditions into account. In order to keep trading, it is enough to be online and keep the terminal turned on during the working hours of the relevant exchanges.

Advantages and disadvantages of arbitration deals

The advantages of this approach include:

  • Low risk, probability of getting profit is higher in comparison with ordinary trading, when the movement of the chart is predicted. Arbitrage strategies are market-neutral, i.e. profits do not depend on the chart direction.
  • Flexibility – the tactic is suitable for most of the assets.
  • Ability to work with different time horizons.
  • It is not necessary to carry out the difficult analysis of the market, to select entry points on the basis of, for example, the graphic or indicator analysis.
  • The possibility of full automation of trade.

There are also disadvantages:

  • Automating trading is not something everyone can do. Some arbitrage systems cannot be implemented in manual mode.
  • Increased complexity as compared to conventional trading strategies. As for where to start earning on arbitrage, it is better for beginners to evaluate this style of work by practicing with manual systems. For example, working with calendar spreads is a good place to start, you don’t need a super high speed of making deals and can trade without the use of Expert Advisors.
  • It is difficult to work with low-liquid instruments.
  • Because of the low risk, the income is insignificant. You need a solid capital to make a tangible income in currency.

All of the above disadvantages are compensated by the fact that arbitrage strategies work and this is proven by practice. At barclayhedge.com indices are calculated that show the effectiveness of this style of trading, they show a stable growth from year to year, which proves the viability of this approach.

The Convertible Arbitrage Index reflects the performance of a standard arbitrage strategy. Convertible bonds of one company are bought and simultaneously shares of the same company are sold.

Statistics show that the strategy works and produces a small but stable income. This is the best proof of the potential of arbitrage trading.

Conclusion

Making money on arbitrage is possible—this is the main thing a trader interested in market-neutral strategies should know. The profits are small compared to classic trading, but the minimal risk makes this tactic an attractive way to work. Some subspecies of arbitrage have become unviable (e.g., trading by ineffective quoting), but others work and will not lose relevance in the future.

The only significant disadvantage of arbitrage is low income. But it is a natural phenomenon, the reduction of risk always leads to the reduction of profitability. The main thing is that this trading tactic allows earning with controlled risk.

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