Arbitrage Simplified: A Comprehensive Guide

Definition

Arbitrage occurs when an asset is priced differently across two exchanges, allowing traders to profit by buying the cheaper asset and simultaneously shorting the more expensive one.

How Arbitrage Works

There are three primary methods to execute arbitrage trades:

1. Betting on Convergence

Process: Buy Asset A on Exchange X while shorting Asset A on Exchange Y.
Assumption: Prices on both exchanges will eventually converge.
Risks:
- External constraints (e.g., halted withdrawals, currency flow restrictions).
- Interest costs for shorting.

2. Moving Assets

Process: Buy Asset A on Exchange X, transfer it to Exchange Y, and sell at a higher price.
Risks:
- Price difference may vanish during transfer time.
- Transfer fees between exchanges.

3. Moving Assets with Insurance

Process: Hybrid of Methods 1 and 2.
- Buy Asset A on Exchange X and short it on Exchange Y.
- Transfer Asset A to Exchange Y to close the short position.
Costs: Shorting fees + transfer fees.

Risks in Arbitrage Trading

While arbitrage is often considered "low-risk," it’s not entirely risk-free. Common risks include:

Time Risk: Delays in execution or transfers.
Exchange Risk: Platform instability or fraud.
Regulatory/Country Risks: Legal restrictions or capital controls.
Liquidity/Default Risks: Inability to exit positions or counterparty failure.

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Multi-Asset Arbitrage

Arbitrage can involve more than two assets, especially in Forex markets:

Example:

If CurA/CurB = 2 and CurB/CurC = 4, then CurA/CurC should be 8.
If CurA/CurC ≠ 8, traders can long CurA/CurB and CurB/CurC while shorting CurA/CurC.

(Note: CurA denotes Currency A.)

Real-World Examples

Cryptocurrencies (2017):
- Prices in South Korea were 30% higher due to capital outflow restrictions.
Gold Futures (Early 2000s):
- Price disparities between COMEX (US) and TOCOM (Japan) even after adjusting for exchange rates.

FAQs

Q1: Is arbitrage truly risk-free?

A: No—while risks are minimal, factors like execution delays or regulatory changes can lead to losses.

Q2: What’s the most cost-efficient arbitrage method?

A: "Betting on Convergence" avoids transfer fees but incurs shorting costs.

Q3: Can arbitrage opportunities last long?

A: Rarely. Markets correct quickly, so speed is critical.

👉 Explore advanced arbitrage tools to capitalize on fleeting opportunities.

Related Concepts

Market Inefficiencies
Statistical Arbitrage (Coming Soon)
Position Sizing (Coming Soon)


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