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Arbitrage

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Definition:

Arbitrage is the process of buying and selling an identical (or very similar) financial instrument at the same time on different markets. For example, exchanging British Pounds (GBP) for US Dollars (USD) in London might be possible at a different exchange rate than in San Francisco, so a profit could be made on the difference.

Requirements

True arbitrage requires that the financial instrument is trading at two different prices, and that the buying and selling trades can be completed at the same time. The simultaneous trade requirement is designed to eliminate any risks associated with holding a trade for any length of time (such as the prices changing against the arbitrage trade).

Trades based upon the same principles as arbitrage might be buying a commodity in one location, transporting the commodity to another region, and selling the commodity in the new region. This type of trade would not be true arbitrage, because the buying and selling trades would not have occurred at the same time.

Examples

  • Stock and stock futures - Buying a stock and selling a single stock futures contract.
  • Stock on different exchanges - Buying a stock on one exchange and selling the stock on another exchange.
  • Mergers - Buying the stock of a company being acquired, and selling the stock of the acquiring company.

Also Known As: arbitrage trading, arbing
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