What is an Arbitrageur?
An arbitrageur is a type of investor who attempts to profit from market inefficiencies. These inefficiencies can relate to any aspect of the markets, whether it is price, dividends, or regulation. The most common form of arbitrage is price.
Arbitrageurs exploit price inefficiencies by making simultaneous trades that offset each other to capture risk-free profits. An arbitrageur would, for example, seek out price discrepancies between stocks listed on more than one exchange by buying the undervalued shares on one exchange while short selling the same number of overvalued shares on another exchange, thus capturing risk-free profits as the prices on the two exchanges converge.
In some instances, they also seek to profit by arbitraging private information into profits. For example, a takeover arbitrageur may use information about an impending takeover to buy up a company’s stock and profit from the subsequent price appreciation.
How Does Arbitrage Work?
The concept of arbitrage is quite simple. By taking advantage of price differences in equivalent assets, an arbitrageur can make risk-free profits by buying low and selling high.
Suppose you can buy avocados from a farm at $1.00 each. Soon after, you sell the avocados to a local restaurant at $1.50 each. In this case, you earn a profit of 50 cents for each avocado you sell.
Financial arbitrage is similar, but the prices of financial assets can change on a moment’s notice. To take advantage of price differences in assets like stocks, the transactions must occur simultaneously to ensure that the prices do not change during the transaction.
What Does an Arbitrageur Do?
An arbitrageur uses trading strategies designed to profit from small differences in the price of equivalent assets. The assets can be stocks, bonds, currencies, commodities, or any other financial instruments that can be bought and sold. Deficiencies in financial markets, such as delays in updating stock prices, can result in prime opportunities for an arbitrageur.
To conduct arbitrage, an investor purchases stocks on one exchange while simultaneously selling the same stock on another exchange. If the transaction happens simultaneously, there is no chance that the stock price will change during the transaction. By selling the same stock at a higher price, the arbitrageur can earn a risk-free profit equal to the difference between the mispriced assets.
Due to the incremental price differences and time-sensitive nature, most arbitrage trades involve institutional investors, such as hedge funds or banks. For most retail investors who trade stocks on their smartphones, arbitrage trades are difficult because of the significant technical resources required to trade simultaneously between various stock exchanges.
Also, the price difference between the two financial assets can be minuscule. Large sums of money are required to take advantage of small price differences to ensure that arbitrage trades are profitable and worthwhile.
Mr Ivan F. Boesky was an example of an Intelligence Arbitrator. During the 1980s, he was considered a master arbitrator in takeovers. He minted money, for instance, by buying stocks of Gulf oil and Getty oil during that time before their purchases by California Standard and Texaco, respectively. In each trade, he’s estimated to have made between $50 million and $100 million.
The emergence of cryptocurrencies gave arbitrageurs yet another chance. As bitcoin’s price hit new heights, many opportunities presented themselves to exploit price differences between various exchanges that operate around the world.
For example, at cryptocurrency exchanges located in South Korea, Bitcoin traded at a premium compared to those located in the United States. The price gap, also known as the Kimchi Premium, was mainly due to the high demand in these regions for the crypto. Crypto traders made the most of arbitrating the price gap in real-time between the two places.