Arbitrage
Family VII · Market & styles
Not to be confused with hedging, scalping, liquidity.
Arbitrage is the practice of buying an asset in one market and selling it in another at the same moment, capturing the gap between the two prices. The two trades are matched in size and timing, so the profit comes from the price discrepancy rather than from a directional view. In liquid markets such gaps are small and short-lived, because arbitrageurs compete to close them.
How the profit is locked in
An arbitrageur does not forecast where a price will go. The gain is fixed at the moment both legs are executed, provided the buy price is below the sell price after all costs. The main risks are execution risk (one leg fills and the other does not), timing risk, and cost risk from fees, spreads, financing and, where relevant, currency conversion.
Because the position is hedged, the return is usually small relative to the capital committed, so arbitrage is often leveraged or run at high volume. The size of the gap that survives costs varies by market, instrument and venue, and is not a fixed number.
Worked example
The 0.12 price gap per share is only worth acting on if it exceeds the round-trip cost of 0.04 per share. If the gap were 0.03, the trade would lose money despite the two prices differing.
Types and limits
Common forms include spatial arbitrage between venues, triangular arbitrage across three currency pairs, and cash-and-carry arbitrage between a spot asset and its futures or forward contract. Each relies on the same principle: equivalent exposures bought cheap and sold dear.
- Execution risk: the second leg may fill at a worse price or not at all.
- Capacity: the mispricing usually disappears as size is added.
- Costs: fees, taxes, borrowing and settlement charges differ by jurisdiction and broker, so the minimum viable gap is not universal.
Often confused with
- hedging
- Hedging is the practice of taking an offsetting position in a related instrument to reduce or neutralise the price risk of an existing exposure, accepting that it also limits the potential gain on that exposure.
- scalping
- Scalping is a trading style that seeks many small profits from brief price movements, typically holding positions for seconds to a few minutes and closing them the same session.
- liquidity
- Liquidity is the ease and speed with which an asset can be bought or sold in a market without materially affecting its price, typically reflected in tight bid-ask spreads and deep order books.