Arbitrage is one of the terms traders will frequently encounter. Arbitrage refers to the simultaneous buying and selling an asset in different markets. It could be identical or in a different form. A trader gains if the price of the same asset is different from its derivative.
Inefficiencies in the market lead to arbitrage. There could be an undervaluation or overvaluation a asset due to a number of factors, including human preferences, cost of transactions or insufficient information. Arbitrage would not be possible if the market was efficient.
There are many types of arbitrage. Arbitrage can be classified according to the level of risk involved. Pure arbitrage does not involve any risk as long as a trader is aware of a price difference. A forex market is an example of pure arbitrage. It's true arbitrage when a forex trader purchases or sells currencies based on their exchange rates at the time.
Risk arbitrage, which is based upon the likelihood of an future event, involves traders or investors weighing the possibility. Because stocks can be purchased during mergers and acquisitions, risk arbitrage is also known as merger arbitrage.
There are many types of arbitrage and different classifications for arbitrage. One classification includes:
Financial Arbitrage: Financial arbitration is typically used to refer to forex arbitrage trading.
Statistical Arbitrage: This method of arbitrage uses extensive data and statistics to track price movements.
Dividend arbitrage This type of arbitrage is where a trader in the options market purchases stock and an equal amount of put options prior to the next dividend date. (ex-dividend). Option arbitrage also known as Dividend Arbitrage.
Convertible Arbitrage: This type of arbitrage is the most common. It involves buying a convertible security and short selling the stock that it underlying. A convertible security is a security that can convert into another type of security. It could be a bond that can convert/exchange into shares of a company.
Arbitrage is also possible in the futures market where futures contracts can be traded. Arbitrage is also known as cash and carry arbitrage.
- Carry arbitrage A form of financial arbitrage in which a trader purchases the underlying asset from the cash/spot markets and then sells the future. Cash and carry arbitrage occurs when the future price of an asset is higher than the cash market.
Reverse Cash and Carry Arbitrage refers to the flipping of cash and carrying. This type of arbitrage involves a trader buying an underlying asset and selling it short. The asset is purchased because it's underpriced, and it is sold because it's too expensive.
Arbitrage occurs in the futures market due to the nature of futures contracts. While an underlying asset or future contract may have the same pricing at expiration, or very close to expiration, prices are different during the time leading up to expiration. Arbitrage uses the price difference.
Arbitrage trading allows investors and traders to profit from pricing differences.
Arbitrage trading is very popular, particularly in the futures section, because it has low risk and is simple.
Arbitrage is a result of market inefficiencies and taps into the price differential between assets in one market and those same or their derivatives in another market. Cash and carry arbitrage and reverse cash-and-carry arbitrage are two of the most common types of arbitrage. These are a combination of an asset and its future contract. Traders can take short or long positions depending upon the price to benefit from any changes in the prices before the expiration date. Arbitrage trading can be done in many ways. To make the most of them you need to know the market and the nature and characteristics of the asset.