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. 

If you want to use arbitrage or any other investment strategy, a financial advisor could help you determine how it fits into your portfolio goals and needs.

Arbitrage Basics

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.

Other Common Arbitrage Strategies for Investors

Arbitrage strategies vary, each designed to exploit market inefficiencies. Each strategy carries specific risks and benefits, so you should have a clear understanding of each approach, and assess how it fits into your investment style and goals before getting started.

Statistical arbitrage, for example, uses math and algorithms to find price differences across securities, and relies on strong data skills and advanced software.

Merger arbitrage, by comparison, focuses on earning from the price gap between a target company’s stock and the acquisition offer, which is profitable if the merger goes through.

Triangular arbitrage, on the other hand, involves trading among three different currencies in the forex market to take advantage of varying exchange rates, and requires fast action and real-time data.

Another simpler method, known as retail arbitrage, consists of buying products cheaply and reselling them at higher prices online, thereby capitalizing on price differences between locations or platforms.

Arbitrage Risks

Arbitrage can be profitable, but you must be aware of several risks that can diminish your returns. One major risk is high transaction costs. For example, if you buy a bottle of single malt in Scotland and incur an extra $25 in baggage fees, you need to sell it for at least what you paid plus the $25 to avoid a loss. This underscores the importance of keeping transaction costs low to ensure profitability in arbitrage.

Another risk involves fluctuating sale prices. If you buy foreign currency expecting it to appreciate but the exchange rate instead falls, you could end up losing money on the deal. This scenario illustrates the need for timely market analysis and understanding, as currency values can shift quickly, impacting your arbitrage strategy.

Lastly, you should consider market conditions and liquidity. If you’re stuck with assets you can’t sell, or can only sell at a loss, your capital is tied up unproductively. For example, in stock arbitrage, if the market moves against you, it may be difficult to offload shares without taking a loss. This lack of liquidity can trap your funds and cause significant financial setbacks. Being aware of these risks is crucial if you’re considering arbitrage as an investment strategy.

How to Use Arbitrage for Your Investments

If you want to get started with arbitrage, first need to learn the different types available and choose one that suits your investment style and budget.

For beginners, retail arbitrage can be a good option, as it involves buying discounted products from stores or online and reselling them at a higher price on platforms like eBay or Amazon. This type of arbitrage doesn’t require a large initial investment and is relatively simple to manage.

If you’re more interested in financial markets, consider statistical arbitrage or currency arbitrage. These require a deeper understanding of financial markets and the ability to analyze data and spot pricing differences. You’ll need to learn about financial modeling and might also need access to real-time market data.

Lastly, setting up your arbitrage operation involves practical steps such as opening accounts on buying and selling platforms, setting up a system to track expenses and earnings, and securing some initial capital if necessary.

For more complex financial market strategies, try using a demo trading account to practice without risking real money. Success in arbitrage requires careful research and planning, regardless of the type you choose.

Bottom Line

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.

Investment Planning Tips

• A financial advisor can help you analyze investment options and mitigate risk for your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• If you want to know how much your investments could grow over time, SmartAsset’s investment calculator can help you get an estimate.
• And, if you want to know how much you could pay in taxes for the sale on an investment, SmartAsset’s capital gains calculator can help you estimate your liability.

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