How do you discover arbitrage opportunities

Arbitrage: possibility of risk-free speculation

The aim of arbitrage is simply to make a profit by taking advantage of price differences, interest rate differentials or price differences in different markets.

For example, a securities dealer can sell shares on one trading venue at a lower price and on another trading venue at a higher price. He usually has a low risk if he relies on stable courses.

However, losses can also be made with arbitrage trades. This is especially the case with strong or sudden price fluctuations.

Origins

The origins of arbitrage go back to Italy in the 14th century. Back then, bills of exchange were bought cheaply by dealers in order to sell them again at a higher price in another place. The process was called "arbitrio". Eventually this method of making a profit by buying and selling in different markets spread across Europe.

However, before the arbitrage could be carried out in its current form, the markets had to be opened up further. It took place as part of the introduction of currency convertibility at the end of the 1950s. Due to the very rapid technical development, the transparency on the markets with regard to prices and exchange rates has increased significantly, so that arbitrage transactions are usually only profitable with large trading volumes.

Speculation vs. Arbitrage

The table below explains the differences between arbitrage and speculation:

speculationarbitrage
Risky form of investmentLow-risk form of investment
High profits possibleProfit margin rather low
Speculation on possible profitsConfident knowledge of profits through almost parallel buying and selling
Possible profit from price increasesUse of existing price, interest or market differences
Profit is not always very predictableEasy profit
High profits possible with small investmentsBig investments needed for big profits

Types of arbitrage

There are several types of arbitrage that can be distinguished from one another. You can find out which properties these have in the following table.

Currency arbitrageForeign exchange arbitrage exploits price and exchange rate differences between objects that are possible for the same objects at different trading venues. Through the simultaneous buying and selling of foreign currency, exchange rate differences can be equalized.
Differential arbitrageThis form of arbitrage is the original type of business. In this case, securities are bought at one trading location while they are sold on another exchange. In differential arbitrage, buying and selling are thus directly linked to one another.
Compensation arbitrageIn this type of arbitrage, the arbitrageur chooses the cheapest option to buy or sell his securities in a sub-market. This allows him to balance his own position. The equalization arbitrage thus works without counter-trade and avoids interlocal price differences. The equalization arbitrage can be used to settle balances or credits.
Time arbitrageTime arbitrage is not actually arbitrage, but rather speculation. In doing so, the arbitrageur relies on transactions that are temporally separated and tries to take advantage of futures and foreign exchange transactions. Due to the longer time span, the exchange rate or price differences should be higher. However, this makes the arbitrage business more speculative and involves greater risks.
Space arbitrageDifferential and equalization arbitrage can be summarized under the term spatial arbitrage. It plays a role here that the buying and selling of financial products take place at different trading venues in order to achieve profits due to exchange rate and price differences.

What is the role of short selling?

Short selling can be involved in arbitrage deals. In this way, the financial transactions can be "closed". This means that a financial transaction is hedged by the exact opposite transaction.

In the case of a short sale, the investor does not need to be in possession of the security. He only assures the seller that he will own it at a certain point in time.

Effects of the market situation

The high level of transparency on the money markets and the high level of technology in the financial market mean that arbitrage transactions are becoming increasingly rare. Today, computer systems determine arbitrage opportunities and process arbitrage transactions within a very short time.

These programs monitor foreign exchange, stock or commodity markets around the world. So not only is it difficult to find arbitrage opportunities, but investors have to be very quick if they want to take advantage of these opportunities.

Compensation function for stock exchanges

Arbitrage is said to have an important influence on market transparency and the related compensation function. By buying securities in large quantities, arbitrageurs draw attention to differences in interest rates, prices or currencies. They are quickly followed by other buyers. In this way, the price that was originally lower increases and the price on the trading venue where the security was listed higher increases. This ultimately brings about a price equalization between the trading venues.

questions and answers

What role do the stock exchanges and courses play?

Arbitrage is possible due to price differences in securities or currencies on different stock exchanges and trading venues. Buyers can balance the values ​​through arbitrage deals. The so-called arbitrageurs are of great importance because their actions can lead to a fair price compensation on the stock exchanges.

What are the Arbitrage Objects?

Financial products that are characterized by their market transparency and simple transaction are primarily suitable for arbitrage. Possible objects for financial management are securities, foreign exchange, precious metals, liabilities or derivatives.

Who uses arbitrage?

The arbitrage is mainly used by institutional investors such as insurance companies or credit institutions. You have large amounts of money at your disposal that can be quickly invested in cheap securities that are immediately sold elsewhere. Due to the narrow time window and the comparatively low profit, arbitrage is rarely used by small investors.

How Can The Arbitrageur Benefit In Securities?

An arbitrageur benefits from financial products that he buys on favorable terms and quickly sells at another trading venue on better terms. The difference between the buying and selling price is its profit.

Can you make a profit with bonds?

Anyone who buys bonds can also make a profit by increasing the price of the bond and selling it.

Is Arbitrage Suitable for Every Trader?

Arbitrage is usually only recommended for large traders. For smaller investors, the transaction fees can be higher than the actual profit.

Are Arbitrage Profits Taxable?

If you make profits through arbitrage, these should be recorded as speculative profits. In this case, Paragraph 23 of the Income Tax Act (EStG) in Germany applies, according to which you have to pay tax on your profit. International tax liability is also possible. That depends on which objects were used to make a profit.