What is Arbitrage

Arbitrage is a trading technique investors use to take advantage of opportunities created by small imbalances in prices for similar or identical commodities competing in different markets. The goal of successful arbitrage trading is to make a quick profit margin on a trade of commodities when the value of one of the commodities has dropped relative to the others in a different market and can therefore be obtained for a cheaper price. For example, there is often an opportunity for arbitrage trade in the forex market. If the British pound is worth 2 US dollars and six Israeli shekels in the London exchange, but in Israel, the dollar is priced at 3.2 shekels, it is possible to buy dollars in the British exchange and trade them in Israel for the higher rate to take advantage of the price imbalance. The different in price for the identical commodity provides the profit margin in the trade.

The No Risk Trade

In most cases, the imbalances tend to be extremely fleeting, if they occur at all, so one must be prepared to jump into the market and start trading, even for a small profit margin when they occur. Another way of looking at arbitrage is to consider the price differential between the cost of something and the ability to immediately sell it off at a higher price. Home prices often create opportunities for arbitrage because there is no set price for real estate, only what people are willing to pay. In other words, it may be possible to find a home that is on the market for a low price - possibly because the home owner needs to sell off assets quickly to increase his cash flow - then to put it back on the market right away and find a buyer willing to pay a higher price. The profit margin in that trade would be the different between the cost at purchase and the cost at the resell. That type of arbitrage occurs more frequently.

Trading in Commodities

Although arbitrage is considered to be low risk or no risk trading, it remains difficult to make a great deal money in arbitrage for too long. One factor that prevents it is the natural balancing that takes place in most markets, especially when demand increases. In the example of the currency exchange, if people started to purchase the dollars in London at an increased rate, the price would go up as a result of the higher demand, closing the imbalance through the natural processes of the market. It is also difficult to plan a business around locating underpriced homes on real estate market. While it may be possible to luck into such an opportunity once in a while, it cannot serve as the foundation for a business strategy.