a close look at arbitrage

Being a trader opens you up to a whole new world of opportunities. You see, there are so many tips and tricks that you can learn from your mentors, and you can use these tips and tricks to try and make it big on being a day trader.

In the previous articles, we’ve learned a lot about these techniques, and we’re here to introduce one more to you. Today, we’ll be looking at the concept of arbitrage. This is a very useful concept to master, but it does require one to keep a sharp eye on not only one market, but multiple markets, at the same time.

What is Arbitrage?

When a trader holds a security in two markets, then he or she is considered to be trying to take advantage of an opportunity to earn from an arbitrage. How does a trader earn from arbitrage? It’s simple; the trading must involve a miniscule difference in individual prices for that same security in the two markets.

Let us look at the sample scenario involving a fictional security, which we will name stock XYZ. Remember that at this point everything is theoretical and fictional, especially the share prices. We use the following figures just to illustrate the point.

Now, let us say that XYZ is trading at both the New York Stock Exchange and the London Stock Exchange at prices of $1.50 per share and GBP2 per share, respectively. Let us also establish that the exchange rate is $1.5 to GBP1. You can see that there is a 50% spread already, but we’ll touch on that later.

As for the scenario – our theoretical trader decides to purchase 100 units of shares in XYZ in the New York Stock Exchange before the markets close on Monday afternoon. By the time the London market opens ahead of the NYSE the next day, trader sees that XYZ is trading at GBP2 per share.

Given the exchange rate of $1.5 to GBP1, we can see that the price of stock XYZ has doubled in the London Stock Exchange. It is now valued at $3 per share, given the foreign exchange. We see that the trader has an opportunity for arbitrage, and he moves to sell his holdings at the London Stock Exchange instead of the NYSE.

Let’s do the math. He bought stock XYZ at $1.50 per share, then sold it at GBP2 each. Given the forex rate of $1.5:GBP1, multiply 2 by $1.50 and he now has $3 per share. Multiply that by 100 units and he has worth $300 when he sold the stock in the London Stock Exchange. He has earned $1.5 per share, and $150 total in the transaction.

Arbitrage is different from hedging, although they may look similar. Hedging involves the investment in securities outside the main security being invested on, for the purpose of minimizing possible losses that could be brought about by the changes in stock prices as well as foreign exchange markets.

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Photo credit : .creative-commons-images.com

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