What is arbitrage and how to use it in the market

💹 The price of the same asset on different markets and platforms may differ, which creates opportunities for profit. This is what arbitrage is. Let’s figure out what it is, what types of arbitrage trades are available to investors, and how you can make money on it.

What is arbitrage

Arbitrage (from a French word meaning “fair decision”) is a strategy in financial markets that involves the simultaneous buying and selling of the same asset on different platforms or markets to profit from a temporary price difference.

A simple example: two markets in the same city. In the first one, an apple costs 50 “money”, in the second one it costs 55. You can buy an apple for 50 and sell it for 55, earning on the difference. This is classic arbitrage.

Modern markets are very efficient and react instantly: price discrepancies disappear within seconds thanks to market makers and traders using high-frequency algorithms. However, opportunities for profit remain: when an asset is clearly undervalued or overvalued due to limited access to information or emotional decisions made by market participants.

Borrowed funds can be used for pair trades, more details — in the section on margin trading.

Where you can earn

On the derivatives market. Here inefficiencies often arise due to the difference between the current value of an asset and the price of a futures contract, which takes into account rates, expectations of price growth or decline, costs, and dividends.

Example: currency futures are often traded in contango — the futures price is higher than the currency itself. If the dollar has fallen in price while the futures value has remained the same or increased, an arbitrage opportunity appears: buy the currency and simultaneously open a short on the futures, earning on the difference by the time of execution.

The trade is almost risk-free. It’s not necessary to work with two instruments for one asset: if a futures contract usually costs 3% more than the currency, and now the spread has dropped to 0.5%, you can buy the futures, expecting the spread to return. This approach carries more risks but opens new opportunities.

On the derivatives market, currencies, stocks, indices, commodities, and precious metals are available. Using statistics, you can determine average differences and find profit opportunities.

Correlation-based arbitrage (Correlation)

Some assets are closely related to each other: for example, preferred and common shares of the same company, or shares of mining companies and the price of the resources they extract.

Example 1: usually common shares are more expensive than preferred ones. If preferred shares temporarily become more expensive than common ones without fundamental reasons, you should buy the common shares and sell the preferred ones, expecting the spread to return.

Example 2: the shares of a coal mining company remain flat, while the price of coal is rising. The shares will probably rise as well, meaning you can buy them.

Carry-trade strategy

This is an approach where money is borrowed at a low interest rate and invested in assets with a higher yield. For example, Ukrainian investors can invest free funds in high-yield bonds instead of early loan repayment.

💡 Main point for investors

• Arbitrage is the search for market inefficiencies (undervaluation or overvaluation of an asset) that you can profit from until the price returns to normal.
• You can open two trades simultaneously (buy and sell), or only one if there is no second instrument.
• You don’t have to arbitrage on two exchanges: inefficiencies can be found on one market or in different instruments for the same asset.
  
• You can find the idea using statistics, and margin lending may be required to implement it.