Arbitrage necessarily means purchasing and selling almost simultaneously to profit from the differences in the price levels. This concept can be traced back even to the times of barter exchange when, on the market day people would meet up to exchange commodities.
In such a scenario, there were some people who exchanged against some valuable commodities. These valuable commodities where then immediately transferred to some other people against something that was even more valuable.
The person who was smart enough to purchase at a smaller price and sell at higher price, was able to land up in the possession of the most valuable commodities or more number of commodities. This trading system is in existence even today and we can observe it all around us. It is a misconception that arbitrage trading is used only Forex and stock trading.
Common Method of Arbitrage Trading
As mentioned earlier, arbitrage trading involves the simultaneous purchase and sale of a certain commodity to profit from the price differences. To understand the phenomenon more properly, let us consider the demand and supply analysis of commodity X.
In the modern markets, it has been observed and proved that the forces of demand and supply dedicate the price levels. The producer introduces a commodity X at a certain price in the market.
If the demand for this supply goes on increasing, then, the initial price level inflates. If the supply goes up in proportion to the demand, then the price level remains the same. If the supply becomes more than the demand, then the price drops down.
Thus basically the demand and supply's fluctuation causes the prices to rise and fall. In such a case, when the demand of the constant supply remains the same, the prices start rising up.
This is when the arbitrage traders buy commodities at a lower price and sell at a steadily rising price, almost simultaneously. This is the basic arbitrage trading mechanism, though in the stock and currency markets it is treated a bit differently.
Arbitrage Trading in Different Markets
Some people might consider arbitrage on a rising graph as a form of robbery, however, it is a very smart trading strategy. Here is how it's observed in different markets in the world.
Commodity and Goods Markets
The aforementioned arbitrage trading strategies were based upon the common goods market. In some nations, traders involved in the arbitrage trade are known as 'middle men'. At times, arbitrage of basic necessities is banned as it leads to drastic inflation of general price levels.
Arbitrage in Stock Exchanges
Such trading strategies are common in all stock markets and stock exchanges. These are two basic ways in which this strategy can be implemented. It can involve the shares of a company, where the buy and sell is very quick, within a few seconds or minutes.
The second way is where the shares are brought in one stock market and immediately sold in another market. Some investment companies have an arbitrage trading program, where this activity is conducted on an every minute-basis.
In Forex trading, arbitrage system is used extensively. Investors simultaneously purchase a weak currency and sell a progressively rising currency. Though this strategy is used extensively, it is the most difficult strategy to execute, as the value of currencies tend to change even by the virtue of seconds.
The arbitrage trading system, though used in several instances and markets, is criticized by some people due to the fact that it leads to inflationary cycles.