Welcome to the Investors Trading Academy talking glossary of financial terms and events.
Our word of the day is “Arbitrage”.
Arbitrage occurs when an investor simultaneously buys and sells an asset in an attempt to benefit from an existing price difference on similar or identical securities. The arbitrage technique enables investors to self-regulate the market and aid in smoothing out price differences to ensure that securities continue to trade at a fair market value.
Given the advancement in technology it has become extremely difficult to profit from mispricing in the market. Many traders have computerized trading systems set to monitor fluctuations in similar financial instruments. Any inefficient pricing setups are usually acted upon quickly and the opportunity is often eliminated in a matter of seconds.
Arbitrage is basically buying in one market and simultaneously selling in another, profiting from a temporary difference. This is considered riskless profit for the investor/trader.
In the context of the stock market, traders often try to exploit arbitrage opportunities. For example, a trader may buy a stock on a foreign exchange where the price has not yet adjusted for the constantly fluctuating exchange rate. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange, and the trader makes a profit from this difference.
By Barry Norman, Investors Trading Academy