What exactly is Arbitrage?

The subject of arbitrage can get very complicated but I firmly believe there are some very simple explanations that can deliver the point to anyone with some basic understanding of how markets operate. I'll start the discussion about arbitrage with a simple theoretical example and then move into some complex and realistic examples. Be careful not to take the simple example as a full explanation. As with any complex topic, there is a simple explanation that typically only scratches the surface and when one takes the time to dig deeper and exercise some brain power, a much broader understanding of the topic can be achieved and the value of that knowledge is greatly increased.

A very basic definition of arbitrage is a transaction based on the observation of the same product selling at two different prices at different locations. The transaction itself involves buying the product at the low price and selling it at the high price and locking in the profit.

In order for arbitrage to work properly, the product must be identical and the arbitrageur must take into consideration carrying costs, transaction costs, or transportation costs to move the product. A basic example would be buying a case of bananas at the farmers market on the east side of town for $8.00, traveling to the farmers market on the west side of town and selling the same bananas for $12.00. Let’s ignore transportation costs for now and just assume the price paid represents the total expenditure for the transaction. The arbitrageur in this example is taking advantage of a locational price difference. For whatever reason, bananas on the west side of town go for 4 bucks more per case than bananas on the east side of town. In order for the arbitrageur to take advantage of the situation, he must first know about it. Being in "the know" is the name of the game. In the basic definition at the beginning of this paragraph a very important term used is "observation." If there is no mechanism for studying market prices, there is little opportunity for arbitrage. The banana man may have called a friend on the east side, or he may have driven by all the markets in town looking for an opportunity. The banana man would not just buy and transport one case, but he would move as many as possible until the opportunity no longer existed. Getting back to the basics of markets discussed earlier, the banana supply shift from the east to the west should cause the prices to level out. As there become less and less bananas in the east, the supply/demand imbalance causes the prices to rise. In the west, the opposite happens and eventually bananas are priced the same as word gets out and people change were they shop for bananas or more arbitrageurs move in.

The critical steps in the process are the observation, or market analysis, and moving on the opportunity before it is gone. We will cover in detail the market analysis in the analytics and cherry picking parts of this book. Moving on the opportunity is a result of the analytics: an opportunity is exposed; you pull the trigger and lock in some cash.

The identical nature of the product is also very important. Arbitrage strategies are typically found in commodity markets where traders can buy and sell contracts for the right to buy or sell a commodity such as coffee, oil, wheat, or pork bellies. These contracts are known as Forward or Futures contracts. The contract specifies the details of the commodity such as quality, size, delivery location, etc. These 'specs' allow the traders to confidently buy and sell the contract knowing that the underlying commodity itself is identical.

Let’s explore a more detailed realistic example...

Arbitrage Example

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