Arbitrage is the practice of buying and selling assets over two or more markets as a way to take advantage of different prices. For instance, a trader could buy a particular asset in one market and quickly sell the same asset in another market, at a higher price.
The reason why arbitrage exists is due to inefficiencies in the markets. This means that a particular asset may present distinct trading prices in different locations, even though both markets are offering the exact same asset (or very similar ones).
In the context of financial markets, arbitrage is often considered a fundamental force because it prevents distinct markets from creating significant price disparities among similar or identical assets. Therefore, the practice of arbitrage relies on small price divergences and, as a result, tends to cause a price convergence. The speed at which this convergence occurs may be used as a measure of the overall market efficiency. A perfectly efficient market would present no arbitrage opportunities at all as each trading asset would have the exact same price across all exchanges.
When performed correctly, arbitrage may be considered as a risk-free way to capitalize on temporary price disparities. Still, one should keep in mind that trading bots are running on all kinds of markets and many of them were specially designed to take advantage of arbitrage opportunities. Therefore, arbitrage trading may present some risks depending on the strategy and execution.
Although we have at least ten different types of arbitrage strategies, traders are often referring to the one we just described, which is the more traditional form and is known as pure arbitrage. Since this strategy relies on the discovery of market inefficiencies and price disparities rather than speculation, it is often considered as a low-risk approach.
Another less popular method is called merger arbitrage (or risk arbitrage), and as the name suggests, it is a highly speculative approach that relies on a trader’s expectation of a future event to affect the price of an asset. This may include, for instance, companies acquisitions, merges, or bankruptcy filings.