The basic concept of arbitrage is simple, and it is one of the basic trading strategies that have been widely used by traders in all markets. The origin of arbitrage trading can be traced back to the times when commodities were used as currency.
Since then, traders have been strategically purchasing goods on a very large-scale at a very low price and hoarding it, thereby creating what is known as an artificial scarcity'. And they have been tactfully selling the same at a much higher cost in times of the 'scarcity'. Thus the principle is simple: 'purchase at lower and sell at higher'.
About Arbitrage Trading
Before you have a look at the arbitrage trading strategy, let us have a look at what is known as the demand and supply analysis, and its effect on the prices of commodities. A demand is the potential capability of the people to purchase the commodity.
In the stock exchange and Forex market, the demand is the potential of investors to purchase a commodity at a given price. The supply in case of a normal market is the actual ability to sell it at a given price.
Thus, the basic equation is that the number of units demanded and the number of units supplied are used to derive the price of the commodity. You need to follow two basic rules:
- If demand is more than supply, this increases the price or market cost of the commodity.
- A decrease in demand and increase in supply reduces the price or market value of the commodity.
The conclusion of these basic concepts is 'sell at a higher price and purchase at a lower price'. The key point where you gamble your money is selling at a price, just before the price goes down (demand becomes less than supply).
Secondly, purchasing an asset that is on its way up at a low price (an asset whose demand at present is low but is going to rise in the near future). These strategies aim at making trades on an hourly basis, and in some cases short trades on a seconds basis are also made.
Arbitrage Trading Strategies
On many trading resources, you will find that arbitrage is done to take advantage of pricing distortions. However, this not the true, because an arbitrage does not exploit pricing mistakes but rather it is done in order to take advantage of price differences. The selling side of arbitrage aims at taking advantage of rising prices due to the rising demand.
The arbitrage trading can be done successfully in two markets, namely stock and securities markets and the Forex market. It must be noted that arbitrage based trading is also observed in several other markets such as the real estate markets and also the common consumer markets, though the best arbitrage effect is observed in a stock or Forex market.
Instead of using some complex options it is always advisable to stick to the common arbitrage strategy so as to minimize the risk of loss.
Arbitrage in Stocks
In the stock market, the best arbitrage trading strategy is to use multiple stock exchanges as selling and buying avenues. In the X stock exchange the price of a stock is bound to be 100 while the price of the same is about to become 90 on Y stock exchange.
The arbitrage strategy in this case is to buy the stock at Y and sell it at X. The merit of such a buy and sell is that there is a zero risk of losing money. There are however chances of going into a no profit no loss situation. The disadvantage of such a transaction is that the rate of profit is very low. The same strategy is used in case of two companies.
Arbitrage in Forex
The second type of arbitrage is that of trades in the Forex. This type of arbitrage is simple as all you have to do is trade between two currencies. One currency should depict a fluctuating rate. The basic method with the help of which the currency can be bought and sold is simple.
Purchase a currency that costs less USD per unit, and sell it for a currency that requires an even lesser USD per unit. This is immensely more difficult than it sounds as it involves an intensive study of the Forex market.
Developing risk-free strategies for arbitrage trading can be very difficult and it is recommended that you have knowledge of economics and trading strategies. You may run risks while implementing these, if you are not careful about the time of sale and purchase. So, research well before you invest!