Trading is a vast field, and it has many different forms. Trade stocks, trade cryptos, trade money, etc., are some commonly known types of trade. But there is another very beneficial trade known as arbitrage trading. If you are still unaware of this term, this article is a complete guide to help you understand this type of trade. So, read on!
What is Arbitrage Trading?
It is the form of trade in which you play with the difference in the same commodity prices in different markets. Does it sound complicated? Let me elaborate. Let’s take the example of gold as a commodity and the US and Japan as the markets. If the price of gold is 59.23 USD per gram in Japan while the price of one gram of gold is $ 60 in the US, buying from the market of Japan and selling in the US market is a straight profit.
Keeping this example in mind, Arbitrage trading can be defined as a trade in which traders buy and sell assets to gain profit from the difference in the asset’s price in two different markets. Hence, the greater the difference, the higher the profit. This trade works due to the inefficiency of various markets. If all markets become equally efficient, arbitrage trade won’t be able to last long. The commodities, assets, securities, or currencies are bought and sold simultaneously in various markets.
Is Arbitrage A Risk-Free Trade?
Arbitrage trading is considered to be a risk-free trade. Why? When you buy an asset at a lower price from one market and sell it at a higher price in another market, there are no chances of facing any loss, and the profit is already evident even before the trade is made. This is why arbitrage trading is recognized as a low-risk to no-risk trade. But the investors know that no-risk is a term that does not exist in the field of trade. The same is the case with arbitrage trading.
The literal meaning of arbitrage involves no negative cash flow as the units are bought from a market that offers a low price and, sold at a market that accepts a high price of the same unit. But, like any other trade, some risks are attached to this type of trade too. The risks may involve fluctuations in the prices of the assets and commodities that may decrease the expected and estimated profit margin or devaluation of a currency that may inflict a significant loss.
In short, arbitrage is a low-risk trade but considering it risk-free or no-risk trade is a folly.
Market Efficiency and The Arbitrage Trade
As explained earlier, traders earn profit by exploiting the price discrepancies. Thus, the traders and investors, in turn, contribute towards market efficiency. If you are aware of the law of one price, you are right to think that this is a clear violation of the law. The law states,
“The price of a commodity or an asset should remain same globally, regardless of location, while considering certain essential factors.”
This law ensures a frictionless market where transportation cost, currency exchange rates, transition costs, and any other legal restrictions do not affect an asset’s value. Similarly, any type of manipulation of the prices by buyers or sellers is prohibited according to the law of one price.
Traders may gain profit by this exploitation of the law. Simultaneous buying and selling of a commodity at a lower price and higher price respectively, will attract more investors. These traders will further benefit themselves from the market price discrepancies, consequently exploiting it. In this way, the arbitrage opportunity will gradually disappear because the asset’s market price starts balancing out globally. This is called price convergence that leads to purchasing power parity.
Why Is Arbitrage Trade Legal?
After reading about the effect and relationship of arbitrage trade with the market efficiency and the law of one price, you must be thinking that is this trade legally accepted. The answer is a clear yes. Arbitrage trade is accepted as legal in the United States and is also encouraged because it plays a vital role in maintaining market efficiency. Moreover, the arbitrageurs serve as an essential factor for the provision of liquidity in various markets.
There are many strategies that you may follow to gain profit due to market inefficiency. However, when more and more arbitrageurs involve in this low-risk trade, they ultimately lead to convergence of price. This is the reason arbitrage trade is encouraged in most developed countries all around the world.