Arbitrage trading is a type of trading that can provide profit to the investor without actually causing him or her to take on any risk. The primary objective of arbitrage trading is to take advantage of variations in the price of a security from one market to the next. Many times, an investor will purchase something from one market and immediately sell it in another for a profit. Other forms of arbitrage are utilized by index fund companies and sports bettors.
The idea behind arbitrage is not to buy and hold a security like many investors do. With this type of investment strategy, in individual will purchase and sell almost simultaneously. Another important element of arbitrage is that it is considered to be risk-free.
For example, if a stock is trading for $10 US Dollars (USD) on one exchange and $10.02 USD on another exchange, an investor could purchase shares on the cheaper exchange and immediately sell them on the other exchange. In order to make a large profit, the investor would have to purchase a large number of shares with this strategy. With this type of arbitrage trading, the investor knows that there is little to no risk because the pricing is available in both markets when the purchase is made.
Another type of arbitrage trading is done with index funds. An index fund is basically a portfolio of stocks that mirror a financial index. When stocks are removed and added to the index, the index funds have to do the same thing. Sometimes, index fund companies will conduct a thorough amount of research prior to the financial index making the announcements of which companies will be removed and which ones will be added.
The index fund can then purchase the companies it believes will be included in the index in advance of the announcement. When this happens, the index fund can take advantage of an increase in the price of the stocks. This provides extra returns just by predicting what the index will do.
Another type of arbitrage trading is commonly practiced in the sports betting world. Sports arbitrage involves working with multiple sports books at the same time. Many sports books will publish different odds on sporting events. When this happens, a bettor can place bets in opposite directions at different sports books and make a profit regardless of what happens in the game.