Arbitrage is the practice of quickly buying and selling the same asset in different markets to take advantage of price differences between the markets.
What Is Arbitrage?
Arbitrage traders take advantage of these price differences by near-simultaneously buying of an asset in the market where it is cheaper, and then selling it in the market where it is priced higher.
The main reason for the existence of arbitrage is usually market inefficiencies. Arbitrageurs profit from this by making markets more efficient, ensuring that the same asset is similarly priced across different exchanges. By buying on the cheaper exchange and selling on the more expensive one, arbitrageurs narrow the “spread” that exists between these exchanges, thus reducing the opportunity for arbitrage and therefore making markets more efficient. Arbitrage is a crucial force as it ensures that no assets deviate from their fair value for prolonged periods of time and enhances the flow of liquidity between exchanges.
Given the nature of the way that arbitrage is executed (buying and selling the same quantity on different exchanges), the arbitrageur takes little to no price risk on the strategy. However, there is risk involved in arbitrage, which comes from needing to execute the strategy near-instantaneously and the cost of trading (commissions). Arbitrageurs usually end up paying a lot in commissions as every unit of trade requires the trader to pay the different exchanges he/she is trading on.
The development of technologies, such as automated trading, tends to eliminate opportunities for arbitrage trading much more quickly, making the practice more difficult for the traders. However, for as long as markets remain not perfectly efficient, arbitrage will continue to perform its vital function.