Arbitrage is the simultaneous trading at different locations in order to exploit the smallest price differences. It is a low-risk form of trading. We explain how this is possible and why it is not quite so simple after all ...
The most important in a nutshell
- In arbitrage trading, traders take advantage of the smallest price differences between trading venues
- Such price deviations are minimal and are often closed within a few seconds
- Financial institutions have technological advantages and use arbitrage trading very successfully. For private market participants, on the other hand, successful arbitrage trading has become almost impossible
- In other forms, however, the concept can provide important input and is of great significance for retailers
Arbitrage trading: definition and meaning
Assets such as shares, bonds and options are traded on stock exchanges. The price of these assets is calculated on the basis of supply and demand. A look at the extensive offer from CapTrader shows: Dozens of exchanges around the world are available for trading!
But the prices are not always exactly the same. There may be minimal deviations between the individual trading venues. In arbitrage trading, market participants try to exploit these differences.
If they discover a price difference, they buy the respective share, bond, ETF, forex currency, etc. at the cheaper location and sell it immediately at the higher price on another exchange.
This could look as follows, for example:
- One share is sold on the London Stock Exchange for the equivalent of € 17.89
- The purchase price for the same share on the trading floor in Frankfurt is € 17.94
- An arbitrageur buys several hundred of these shares at the lower purchase price in London
- He sells them immediately for the higher price in Frankfurt. He makes a profit of 5 cents per share
This means Arbitragewhich means "at your own discretion", in contrast to speculationArbitrageurs profit from immediate trading in different locations, while speculators are active over a period of time (but in the same location).
Although the earnings from arbitrage trading initially look very low, it offers lucrative opportunities: Financial institutions and other professional market participants use particularly powerful, automated computer systems for arbitrage trading.
This enables them to achieve very high profits through constant repetition. Private traders can also make targeted use of deviating prices. However, as they neither have the necessary infrastructure nor the enormous capital of financial institutions, classic arbitrage trading is no longer suitable as a stand-alone strategyHowever, it can be an important indicator!
How do the price differences come about?
Trading arbitrage is not only important for traders; economists are also very interested in trading arbitrage. minimal price differences interested. Because they represent an inefficiency and, if economic theories are to be believed, should not exist at all.
But economics is not an exact science and markets are not perfect.
| Theory | Reality |
| Prices on the exchanges are created by supply and demand | Prices are determined by supply and demand as well as a variety of other influencing factors |
| Market participants know the real value of an asset | Market participants can only roughly estimate the real value of an asset |
| Since the real value is known, the price of an asset is also the same on all stock exchanges | As the real value is not exactly known, prices may vary on different trading venues |
| Any price differences are settled immediately | Any price differences are compensated if they are discovered by market participants |
Arbitrage trading proves that the idea that stock exchanges are perfect markets is not entirely correct. However, as price differences today are equalized in a fraction of a second, it is clear that this is a perfect market. almost perfect financial market.
The different prices are equalized when market participants discover them. Arbitrage trading is therefore only possible because there is no perfect exchange of information and the traders are not omniscient.
The following generally applies: The larger (and therefore more lucrative) a price deviation is, the faster it will be closed by market participants in search of profits. Liquidity also plays an important role in this context! This is because the more frequently an asset is traded, the faster its price adjusts.
As a result, private traders can, for example, use the typically very liquid Shares for day trading hardly hope to find deviating prices. In the case of illiquid securities of small companies, on the other hand, it is still possible to come across mispricing.
It is not without reason that one of the most important Trading tips for persons who use the Learn to trade to ensure sufficient liquidity - or, in the case of arbitrage strategies, to specifically avoid it.
Arbitrage forms
Arbitrage occurs in trading in different forms on. They include practical trading strategies as well as theoretical concepts. The most important examples are
1. "Classic" trading arbitrage (one asset)
An exchange-traded asset has a different price on two different trading venues. A trader can make a profit by buying at the lower price and selling at the higher price.
As a result of such transactions, the two prices continue to converge and the divergence is closed. Today, this process often only takes a few fractions of a second, as institutional traders can use the High frequency trading keep an eye out for such price differences.
Private individualswho wish to execute such arbitrage strategies must also rely on automation, but are clearly at a disadvantage. They hardly have access to the necessary hardware or capital to effectively exploit price differences. This is why traditional arbitrage trading is now almost only of interest to financial institutions.
But the concept is also of great importance outside the financial markets:
- Arbitrage also occurs in trade: For example, an importer/wholesaler buys products from a manufacturer in Asia at a very low price and sells them for significantly more in Europe. The price difference, after deducting other costs, represents his profit.
- This is also based on a mismatch between the individual markets: diverging prices between Asia and Europe allow arbitrage profits to be made.
- Differences rarely last long: the potential profits quickly attract other retailers. Prices in Europe fall due to stronger competition, while increased demand in Asia leads to a price increase. Both markets converge and the divergence is reduced.
2. dual arbitrage (two assets)
Trading arbitrage can also be used with two different assets if there is a strong correlation between them.
Typical examples are
- Shares in the same sector whose prices are strongly correlated
- Closely related raw materials in the Future Trading or with Commodity optionswhich typically move synchronously
- Different ETFs that track the same index
- Fixed-interest products from various issuers, such as Short-term bonds of two similar states.
- Interest on the currencies of similar countries
- Cryptocurrencies with a similar structure
Here, too, price mismatches can occur. If the prices of the two assets deviate from each other in exceptional cases, there is an opportunity for arbitrage profits. If a trader expects the prices to converge again shortly, he can open corresponding positions:
- Lower-lying asset: Alignment with the higher-ranking asset possible through price increases. The trader can profit from this by taking a long position.
- Higher standing asset: The higher prices could be temporary and align with the lower asset. By selling short, a trader can generate profits when prices fall.
- Both assets: Of course, it is also possible that the prices of the two assets meet "in the middle". A trader could open both a long and a short position in order to profit from both movements.
Good to know:
Arbitrage transactions with interest rates are also referred to as interest arbitrage. This occurs, for example, when a trader lends money in a currency (e.g. via Debt capital trading) and converts it into another in order to achieve higher interest rates there.
Interest arbitrage can also be used with Forward exchange transactionsfutures or forwards. Depending on the variant, risks and opportunities may be greater or lesser. If you would like to learn interest arbitrage trading, a longer trial phase is recommended due to the strategic depth.
With the CapTrader Paper Trading Account provides you with a free opportunity to try out trading in complex financial products. Here you can use futures and co. in a realistic trading environment without any real risk.
3. triangular arbitrage (three assets)
Arbitrage trading is also possible with a detour via another asset. This is known as triangular arbitrage or triangular arbitrage. It is particularly Forex trade and is also based on price differences:
- A trader exchanges currency 1 for currency 2
- It then converts currency 2 into currency 3
- Currency 3 is now exchanged back into currency 1
Price deviations result in a profit in the third step. Of course, not just any currency pairs can be selected for this purpose: Market participants must first identify corresponding deviations and then execute the triangular trade as quickly as possible.
Due to the extremely high liquidity of the forex market (almost USD 7 billion in currencies are traded every day), such opportunities never last long.
Please note: Due to the three transactions required and the generally low profit margins in arbitrage trading, trading fees are particularly important here. Even slightly excessive costs can greatly reduce the effectiveness of triangular arbitrage.
CapTrader can do that:
Thanks to forex trading from €3.75 and an extremely low spread of just 0.1 pip, trading at CapTrader is particularly favorable. With the right lot size, impressive profits can also be achieved with three-share arbitrage!
4. arbitrage as a basic financial concept
The term arbitrage is increasingly being used today outside of trading for all kinds of advantages in financial transactions. Financial influencers, advice portals and the like use the term to describe a kind of "common financial sense":
- The general exploitation of price advantages, for example through discount campaigns and special offers or the selection of the cheapest possible retailer.
- Targeted reallocation of capital to maximize interest income (switch from offer A to offer B if higher interest rates are available).
- Basic money management and sensible use of capital, for example paying off loans taken out with the highest interest rate first, etc.
Of course, the use of the term is not entirely correct: it is more a general use of financial benefits. These processes have little to do with arbitrage trading in the financial sense.
When is arbitrage trading worthwhile?
Classic arbitrage trading (price differences for a single asset on different stock exchanges) is dominated today by institutional traders. It is increasingly difficult for private individuals to discover the often minimal price differences and exploit them promptly.
However, arbitrage remains extremely important as a fundamental concept of the financial markets. It influences retailers in many different ways:
- Deviations from the usual prices are very significant Trading signals! Whether you want to invest in shares, futures, ETFs or Trade optionsWhen an asset departs from its usual price trend, this can offer an exciting opportunity for traders.
- There are sharp price changes on the stock marketwhen one company buys another. Dealers regularly acquire Securities of companies that are in sales negotiationsin the expectation that their price will rise after the merger. However, such a transaction involves risks (the deal could fall through). It is therefore also referred to as risk arbitrage or merger arbitrage.
- Pair trading, i.e. trading with a particular focus on links between two assets, can also be very lucrative. In this form of trading arbitrage, profit opportunities arise from price gaps between two partner assets.
- Arbitrage in trading shows traders the importance of price differences, spreads and choosing the right trading venue. It thus performs an additional andragogical task and helps newcomers to the Learn to trade would like to.
CapTrader can do that:
The importance of the best (most favorable) trading venue is underestimated by many traders! CapTrader offers you over 170 trading venues in 37 countries and allows you to trade in an optimized way for the best possible results!
Possible risks of an arbitrage strategy
Arbitrage trading is often described as "risk-free profit". However, this does not correspond to reality, at least from the perspective of private traders! A lot can go wrong with arbitrage transactions:
- If a trader buys an asset with the expectation of reselling it for a higher price on another trading venue, time plays an important role. Price differences are settled in fractions of a second and could already be closed before the sale has been executed.
- The profit margins in arbitrage trading are often very low. Before each trade, it is therefore important to check carefully whether a positive result is actually left over. Calculation errors, a wrong strategy, etc. can quickly lead to losses.
- Broker fees, spreads, commissions etc. also have a negative impact on the results and the arbitrageurs. As with other approaches with small profits and high frequency, an arbitrage strategy also relies heavily on favorable conditions.
CapTrader can do that:
In order to preserve your arbitrage profits, you should choose a broker that is as favorable as possible. At CapTrader you will find particularly attractive conditions and excellent spreads: Trade shares and ETFs from as little as €2.00, futures from €1.00, forex from €3.75, options from €2.00 and much more!
Conclusion: Arbitrage trading has enormous significance for the financial world!
Records a If the prices of the traded goods differ on different trading venues, a profit can be made by buying and selling immediately. This form of trading is known as arbitrage.
Arbitrageurs use a Variety of methods to trade one, two or three assets without waiting. Unfortunately, such price differences between exchanges are rare in the age of high-frequency trading.
Within fractions of a second, the deviating prices are balanced out by institutional traders. Other market areas, such as triangular arbitrage in forex trading, are better suited here and continue to offer attractive opportunities.
In general, the Profits with arbitrage strategies tend to be manageable. However, if executed correctly, their risk is also minimal. Through constant repetition, arbitrageurs can generate attractive returns.
Please bear in mind that fees are charged for each trade, which can have a significant impact on your results. Good money management and the choice of a favorable broker such as CapTrader are therefore essential!
