Arbitrage: The Closest Thing to a Free Lunch!
You have probably heard of the saying “There’s no such thing as a free lunch.”
It means you can’t really get something for nothing. On Wall Street, this applies to the relationship between reward and risk.
The idea is that if you want a small risk of loss (or none at all), you will usually have to invest in something that’s expected to yield a low return. If you want a higher potential return, usually you will have to invest in something riskier—something that could make a sizeable move up or down.
However, there is one type of very short-term trade that’s considered risk-free. It is called arbitrage.
How Arbitrage Works
In simple terms, it means buying something in one market and selling it right away in another market. Here’s an example of how it could work.
A stock that is listed on exchanges in multiple countries presents a potential arbitrage opportunity. For the same stock, U.S.-listed shares will trade in U.S. dollars (USD), whereas Canada-listed shares will trade in Canadian dollars (CAD).
Ideally, all markets should be efficient, and arbitrage wouldn’t be possible, but in reality mispricings will temporarily occur.
For example, Canadian gold miner Barrick Gold trades on the New York Stock Exchange (NYSE) under the symbol GOLD and on the Toronto Stock Exchange (TSX) under the symbol ABX. Let’s say that the current exchange rate is 1 CAD = 0.76 USD, and you see that GOLD is trading at 16.60 USD and ABX is trading at 21.70 CAD.
Since 21.70 CAD is equal to only 16.49 USD at the current exchange rate, the U.S. shares are mispriced. A fast-thinking trader could buy ABX from the TSX and immediately sell GOLD in the NYSE. He would realize a gain of 0.11 USD per share.
If he bought and sold 1,000 shares, he would make a $110 profit. This may sound small, but for very little risk and a tiny sliver of time, that’s not bad. And if he can keep finding arbitrage opportunities, the gains add up over time.
In order for this to work, the trader will need to be able to trade on the TSX. Ideally he will execute the two trades as close to the same exact time as possible. This is because the temporary mispricing could self correct quickly and the arbitrage window would close.
He should also make sure that the arbitrage profit is big enough to cover the trading cost—nowadays, online discount brokers offer very low commission rates, so that should be no problem.
Another Way to Use Arbitrage
Another type of arbitrage is to buy the shares of a company that’s in the process of being taken over. Unlike the first example, the purchase and sale of the stock doesn’t occur simultaneously.
For example, Company ABC bought out Company XYZ for $20 a share in cash, but XYZ is trading at $19.50 a share. If the trader sees no chance of the deal falling through, then he could buy XYZ, hold until closing and pocket the $0.50 per-share profit when the deal closes.
Beware of Opportunity Cost
The drawback here is opportunity cost. If he bought XYZ, his maximum profit is capped at $0.50 per share. He could have used the cash to buy another stock that could have gained more in the same amount of time. The emphasis is on “could” because that stock could also fall.
Losing money is the risk the trader takes when he buys a stock. On the other hand, if he bought XYZ, he’s guaranteed a $0.50 per share return at deal closing. But he gives up potentially bigger gains if he used that money for something else. That’s the trade off.
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