Arbitrage

Submitted by Share Trading on 23 February, 2010 - 13:40

Arbitrage is a type of trading approach where a trader buys and sales similar type of commodities in multiple markets in an attempt to make profit from the discrepancy of the price. A person who does arbitrage trading is called an “arbitrageur”.

In case of arbitrage trading, a trader purchases an asset or commodity from a market where it is offered at a lower price and then sells that commodity in some other market where the price is higher. The price difference in these two markets allows the trader to make profit. Arbitrage is a legally accepted trading strategy and is used throughout the world.

One simple way of understanding arbitrage is by considering an example involving the share market. Let’s say, you have 500 shares of company “ABC”. Now one morning you suddenly found out that the ABC shares are trading at $25 a share in the Australian Stock Exchange (ASX) and at $30 a share in the National Stock Exchange of Australia (NSX). Now in case of Arbitrage trading, what you will do is sell your 500 ABC shares at NSX for $30 per share while at the same time buy back 500 ABC shares from ASX for $25 a share. In the process, you will be making a profit of (5*500) = $2500.

Arbitrage is considered as a less risky trading strategy and as long as you are executing trades in the right time, you should not lose money. Arbitrage trading can be executed from anywhere regardless of in which region you are located in. So this is something that makes the entire procedure quite flexible.

Types of Arbitrage

Arbitrage trading can be classified into various categories:

  1. Merger Arbitrage
  2. Speculative Arbitrage
  3. Statistical Arbitrage
  4. Convertible Arbitrage
  5. Fixed Income Arbitrage

Risk Arbitrage - A Popular Type of Arbitrage Trading

Although this type of arbitrage trading involves risks, but still “Risk Arbitrage” is increasingly becoming popular among the traders. The whole idea of risk arbitrage is buying the shares of a company while another company makes a takeover bid to acquire that company and later profiting from the shares by selling them at a higher price when the takeover becomes effective.

For instance, say there is a company named ABC which has made a takeover bid for company XYZ by asking $20 a share. Now the shares of XYZ are currently being traded at $15 per share. Assume that the earlier trades bid $18 a share for the XYZ shares. Now what an arbitrageur will do is, he will buy the shares of XYZ for $18 a share and later will sell them for $20 when the takeover comes into effect. However, the risk in this type of trading is that the arbitrageur can face loss if the takeover bid fails.

Glossary List

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