Quick definition Arbitrage is buying and selling the same (or equivalent) security in two different markets to profit from a price difference, with zero risk. What it is A pure arbitrage opportunity occurs when the same security trades at different prices on different venues. Buy low, sell high, pocket the difference. Example: Gold futures trade for 1,900 dollars per ounce on the COMEX and 1,905 dollars per ounce on the LBMA. An arbitrageur buys on COMEX and sells on LBMA, locking in a 5-dollar profit. Arbitrage is risk-free if executed correctly. The profit is small but guaranteed. Why it matters Arbitrage is a force for market efficiency. Arbitrageurs find price discrepancies and trade them away, pushing prices back to equilibrium. Arbitrage is highly competitive. Tiny profit opportunities are competed away rapidly. Only firms with low latency and low costs can make money from arbitrage. Spatial arbitrage Spatial arbitrage exploits price differences across venues or geographies. A stock trading at different prices on NYSE and NASDAQ, or a commodity trading at different prices in New York and London. Temporal arbitrage Temporal arbitrage exploits price differences over time. Forward contracts and futures should trade at prices consistent with spot prices plus carry costs. If not, arbitrage opportunities exist. Statistical arbitrage Statistical arbitrage is not true arbitrage (it is not risk-free). It exploits statistical relationships that should hold but sometimes diverge. True arbitrage is risk-free; stat arb is risky. Practical example Gold spot price: 1,900 dollars per ounce. Gold 3-month futures contract: 1,910 dollars per ounce. Storage and financing cost: 7 dollars per ounce. True price should be 1,907 dollars (1,900 + 7). But the futures are 1,910. An arbitrageur buys spot gold, sells futures, locks in a 3-dollar profit. See also - Statistical Arbitrage - Merger Arbitrage - Convertible Arbitrage - Cash-and-Carry Arbitrage
