Arbitrage is the buying and selling of assets, profiting from the price difference between the price paid to buy and the price at the time of sale. In a successful arbitrage deal, the turn-around time between buying and selling is minimal and the transaction costs (the cost of buying the goods and bringing them to sale) are low or nonexistent.
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Has a friend ever asked you to pick up a particular product that’s cheaper in another state or country, offering to buy it from you when you get back from your trip? If you’ve taken your friend up on this offer, you’ve engaged in arbitrage. Arbitrage is profiting from the price difference between markets. If you can buy a good or asset in one market and then sell it for a higher price in another market, you make profits in the process.
Arbitrage deals can be as low-key as the one described above, or can take place at lightning speed on traders’ computers. It’s all about taking advantage of price discrepancies that stem from market inefficiencies. Conversion arbitrage, a form of options trading, is an example of a complicated arbitrage transaction that involves buying a stock, selling call positions on the stock and buying put positions on the same stock at the same time, with the same price and expiration date.
That’s way more than you need to know how to invest, say, your down payment fund, but it’s a way some arbitrageurs make money out of money. Arbitrage deals like the options trade described above have led some critics to question the role of arbitrage in financial markets. Should great financial minds be spending so much of their time and effort on arbitrage deals that don’t make anything but instead may take advantage of asymmetry of information in markets? Defenders of arbitrage say it is harmless at worst and at best it can make markets function more smoothly and efficiently.
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Arbitrage works best when transaction costs are low and high prices are guaranteed. To stick with the travel purchase example, if you have to pay $25 in extra baggage fees to bring back a bottle of single malt from Scotland and you sell it for less than the price you paid plus $25 you’ve lost money. That’s why low transaction costs are key to profiting from arbitrage and the risk that transaction costs will exceed profits is a potential downside to arbitrage transactions.
Another risk is that the sale price won’t be high enough to guarantee profits. If a trader buys foreign currency and then the exchange rate adjusts, wiping out the trader’s profits, he or she has lost money on the deal. An arbitrage deal gone wrong can not only cost money – it can leave the trader with a pile of assets he or she can’t unload or has to unload at a loss.
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Everyday retail investors don’t need to engage in arbitrage to save for retirement or build up an emergency fund. You don’t have to become an expert on trading options or currencies to grow your net worth. However, it can be useful to know what the term means and to understand news reports about arbitrage in world markets.
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