When there is purchasing and selling of any asset which is done simultaneously so that if there is any variation in the price, it won’t affect them and there will be complete profit.
Definition of Arbitrage
The profits are got on such type of trading by taking the advantage of the difference in the price of the financial instruments that are either alike or similar which will be available on the different marketplace or sometimes present in another form. Arbitrage came into existence because there was inefficiency in the financial market. If the financial market was efficient the arbitrage would not have existed.
Arbitrage in Depth
When a trader wants a profit that is risk-free what he can do is buy a security from one marketplace and as he is doing so, simultaneously negotiate to sell it on the other marketplace for a significantly high price, this is where arbitrage takes place. There is a mechanism that is provided by arbitrage that will make sure that the price of the security does not diverge substantially from the price at which the security is sold and agreed upon for a longer time.
The errors on the pricing of the securities in a marketplace has become more and more as the technology has advanced over time leading to difficulty in gaining profits. There are traders who have started depending on systems developed for trading that are computerized which are programmed to supervise if there are any fluctuations in the financial instruments that are alike. If there are any pricing that is set and is not efficient there is an action that takes place on it immediately which will lead to the elimination of this opportunity just within a couple of seconds. Making use of arbitrage has become necessary in the financial market.
Example to Understand Arbitrage
Let’s consider an example that is very simple to explain arbitrage: Suppose there are stocks that are traded by a company A. This company trades its stock on 2 exchanges that are New York Stock Exchange and London Stock Exchange. Suppose at New York Stock Exchange the stock is traded at $30 and simultaneously the same stock is traded on London Stock Exchange at $30.05. Noticing this the trader will be buying the shares on New York Stock Exchange and sell it instantly on London Stock Exchange making of profit of 5 cents on each share. The company might continue exploiting this arbitrage till the time the New York Stock Exchange runs out of any inventories of the company or both the stock exchanges adjusts this price to remove this opportunity.