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What are Arbitrage and its types?

The investment market is quite versatile, where users can implement as many strategies as they want, and every strategy has its own benefits. Arbitrage strategy is very popular and we will learn about it in this article.

Investment methods differ from buy-and-hold tactics; even some tactics are very complicated. However, arbitrage trading is considered one of the oldest forms where users benefit from the slight price variation in different markets.

Arbitrage Investment strategy is one of the best trading strategies if a dedicated and potential investor leverages it. However, it also carries many risks, and if you want to include it in your investment strategy, you should know its nuances and the risks associated with it.

Here, we have provided a comprehensive review of arbitrage trading tactics to help you better understand them.

Key Notes

  • Arbitrage is one of the sophisticated trading strategies where users benefit from the small price variation of the market.
  • This type of trading is useful for those traders who have an eagle eye and notice small changes in a different currency market.
  • These Arbitrage trades are made in commodities, stocks, and currencies.

What is Arbitrage?

Arbitrage is a popular investment strategy that helps users to generate profit by buying and selling assets in different markets simultaneously. It benefits from the short-term variation in the price of similar and identical assets in different trading markets.

For e.g.:-If an asset is trading at $5 On the NYSE market and at the same time, it is trading at $ 5.5 on the LSE; you can buy immediately $5 On NYSE and sell at $ 5.5, making a profit of 5 percent.

By trading on different price variations, users take advantage of this trading opportunity and make profits. Hedge funds and some sophisticated investors mainly leverage this strategy.

Apart from this, users should also know about global macro, another arbitrage investment strategy. Still, it mainly refers to investing only during economic changes between countries. But, it is not over here; now let us know about different types of Arbitrage strategies.

Types of Arbitrage Strategy

  • Pure Arbitrage

Pure Arbitrage describes the trading strategy in which investors buy and sell the same assets in different markets to profit from price differences. So the term arbitrage and pure Arbitrage can be used interchangeably.

If assets are being traded on different markets, there could be price variations, so these price variations could be used to make arbitrage trading opportunities. When investors are dealing in multiple markets, the price of assets may fall out of sync. It is the time when time difference will take place, and pure Arbitrage can become possible.

The main aim of using the Pure Arbitrage strategy is to take advantage of market inefficiencies. But as we know, technology is improving, and pricing errors can be easily identified, making this strategy a rare occurrence.

  • Merger Arbitrage

Merger arbitrage, also referred to as Risk arbitrage, is a type of trading strategy that involves two merging entities, such as two public businesses. It is a type that is mainly related to merging entities.

The merger generally consists of two parties: the acquiring company and the target. Typically, both entities collaborate to make profits. A targeted company is a publicly traded entity, whereas an acquiring company purchases the shares of the targeted company.

To merge entities, the acquiring company should purchase the outstanding share of the target company.

In some time, the deal becomes public, and the investors can purchase the target company stock and can generate immense profit. Of course, the investors will buy the target company’s shares at a discounted price, and there will be a pure profit if the deal gets final.

In most cases, it is at higher prices than what stock is traded at the time of the announcement, resulting in a profit for shareholders. As the deal becomes public, trades looking to profit from the company purchase the company shares, bringing the price closer to the dealer’s actual worth.

Risks associated with this strategy

In general, it is a risk-free trade, but still, it is prone to various shortcomings –

  • Uncertain market

We all know that the market is still being determined and never runs as per our expectations. Investors can make losses instead of profits if the market doesn’t meet their expectations.

  • Transaction Costs

We cannot underestimate transaction costs in any condition. Users should always know that every market has different fees and brokerage charges. Overlooking these factors will have a significant impact on profitability.

  • Limited Opportunities

Users cannot consider it as a full-time opportunity because the flares are increasing continuously. The regulators are very well aware of these things, and they are eliminating these loopholes slowly, which impact few chances of the success of arbitrage strategies.

  • Convertible Arbitrage

A convertible Arbitrage, also known as convertible notes or convertible debt, is a form of Arbitrage that deals with convertible bonds. A convertible bond is a corporate debt that creates an interest payment for bondholders. However, unlike a traditional bond, it can be easily converted into shares.

Often, companies issue convertible bonds as they offer lower interest payments. Convertible Arbitrage provides users to take advantage of the market discrepancies between the conversion price of the bond and the current share price of the parent company shares.

Conclusion

Arbitrage is a profitable strategy for traders who want to benefit from the price discrepancies of different markets. Economic theory states that Arbitrage will not be possible if the market is efficient.

However, in reality, this situation is prevalent, and traders often use it as an opportunity to make profits. Here we have mentioned some of the common arbitrage trading opportunities; There Are many types of arbitrage trading opportunities in the market that you use to make profits.

FAQs

Q. What are the benefits of Arbitrage?

Ans. Arbitrage allows making a profit from price variations of the different markets. There are different types of arbitrage trading opportunities available in the market which you can take advantage of.

Q. What are Arbitrage and examples?

Ans. Arbitrage trading is buying and selling an identical asset in a different market and taking advantage of the price discrepancies. E.g., if an asset is traded at different prices simultaneously in a different market, a trader can use it as an arbitrage opportunity.

Q. When Does Arbitrage Take place?

Ans. Arbitrage occurs when security is bought in one market and sold in another at different prices, usually higher than actual prices. The temporary price variation in the different markets gives an opportunity to make profits.