Arbitrage trading means buying and selling the same asset in different markets simultaneously to exploit price differences. It capitalises on brief moments where the same asset has different prices in separate markets.
This trading form is crucial for financial markets as it helps maintain price efficiency across different trading platforms, ensuring no single market can drastically misprice an asset compared to others.
These are the types of arbitrage trading:
It uses mathematical models to identify and exploit pricing inefficiencies between securities. Traders analyse historical price relationships and patterns to predict future movements.
For example, a trader might use statistical models to identify two historically correlated stocks that have recently diverged in price. The trader bets on their prices converging again by buying the underpriced stock and selling the overpriced one.
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Merger arbitrage is trading stocks of companies undergoing mergers and acquisitions. Traders bet on the outcome of the merger. They buy or sell stocks based on predicted changes in stock prices post-announcement.
The main risks include the merger failing to close on terms initially expected or within the anticipated timeline. It affects expected profits. The potential profit depends on the merger’s successful completion and the accuracy of the initial stock price response.
This involves taking a long position in convertible securities (like convertible bonds) and a short position in the issuing company’s stock. The strategy exploits price inefficiencies between the bond and the stock.
Traders execute this by buying convertible bonds and simultaneously short-selling the equivalent shares of the stock. This strategy requires careful analysis to ensure the pricing discrepancies will result in a profit after covering transaction costs.
It trades three different currencies in a triangular route to exploit discrepancies in exchange rates. It’s a common technique in the forex market.
Retail arbitrage is about buying products at a low price in one retail market and selling them at a higher price in another. This can be between online platforms or from physical stores to online. Ideal products for retail arbitrage are those in high demand but available at lower prices due to overstock, clearance, or regional pricing strategies. The markets suitable for this arbitrage type typically show significant price variation for identical products.
Crypto arbitrage exploits price differences of the same cryptocurrency across various exchanges. Due to less regulation and faster price changes, it offers unique arbitrage opportunities. Risks include exchange security threats, withdrawal limits, and sudden regulatory changes. Rewards are high due to rapid price fluctuations, providing significant profit margins if executed quickly.
Spot futures arbitrage is trading the price difference between a futures contract and the spot price of the underlying asset. It gambles on the convergence of these prices at the futures contract’s expiration.
For example, if the spot price of oil is lower than the futures price, a trader might buy oil at the spot price and sell futures contracts. They expect the prices to align by the contract’s expiration to secure a profit.
This strategy exploits pricing inefficiencies between related fixed-income securities such as bonds and interest rate swaps. It usually focuses on discrepancies in interest rates or yield curves.
Arbitrage trading exploits market inefficiencies to generate profits. It also contributes to market stability by ensuring price uniformity. Traders must stay vigilant about evolving market dynamics to remain successful.
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