Market arbitrage is the process of taking advantage of differences in prices for the same commodity in different markets. It allows people who spot an opening to make a quick profit. However, the costs of buying and selling commodities can limit the actual profit made.
In theory any form of commodity which is traded in more than one market can be used for market arbitrage. The most common are financial products such as stocks and bonds. However, arbitrage can work with physical commodities such as gold, oil or foods. It can also work with rival foreign currencies or even sports betting.
The simplest example of market arbitrage would be a commodity where the selling and buying prices on two markets are different. For example, gold may be trading for $1 US Dollars (USD) an ounce on one stock market and $1.05 USD on another market. Somebody buying the stock on the first market and immediately selling it on the second market would make a certain profit.
In its purest form, market arbitrage would involve the two transactions occurring simultaneously. This avoids any risk of the prices changing during the process and means the person buying and selling the commodity is guaranteed to make a fixed amount of money. In reality, although most such deals are carried out electronically, there will be a few seconds or minutes delay between the two transactions. There is a small risk that prices will change during this delay and make the deal less profitable, so many people using arbitrage will aim for deals with enough of a profit margin that it would take a substantial change for the deal to backfire.
There are other limitations to the money which can be made. Because most markets have a different price for people wanting to buy and people wanting to sell, there may be an overlap which wipes out the potential profit from the overall average trading price. There are also usually transaction costs with every trade, which of course means two sets of costs for somebody attempting arbitrage. This means the price differences in the markets need to be much bigger to make the deal profitable.
Usually market arbitrage involves one product, but this isn’t always the case. For example, exchange rates for three currencies may vary across two different markets. Simply buying and selling one currency might not make a profit. However, exchanging currency A for currency B on the first market, then exchanging currency B for currency C on the second market, then finally exchanging currency C for currency A on the first market can wind up with more than the original total of currency A. This is known as triangle arbitrage.
In perfect economic theory, market arbitrage will bring down differences in prices between different markets. Where there is a difference, people will theoretically be sure to exploit it until the prices are so close that arbitrage stops being worthwhile. In reality, human nature means many or most traders will prefer to take greater risks because of the potentially greater profits.
