The subject of arbitrage Taking advantage of price differences in at least two different markets by buying the same security at the cheaper price and immediately selling it at the higher price. is a bit confusing for the new investor, but you will undoubtedly hear the term as you start reading more and more about investing. In its simplest form, arbitrage is taking advantage of price differences in at least two different markets. By making simultaneous deals to maximize this difference, you can generate some profit using an arbitrage strategy.
For example, Stock A has a market price of $45 on one exchange, but has a current market price of $50 on another. Buying shares at $45 and immediately selling at $50 in a different market returns a tidy $5 per-share profit. Because of the global economy and the efficiency of electronic communications, this may be more of a textbook than a real-world example, but this is how arbitrage works.
The most common form of arbitrage is with Mergers and Acquisitions (M&A). When one publicly traded company wants to buy another publicly traded company, they usually must pay a premium for their shares. For example, let’s say Company X wants to buy Company Y. Company Y’s shares trade for $20 and Company X proposes to buy them out at $30/share or a 50% premium.
Here’s where the arbitrage stock trader comes in quickly. Seeing that there is a proposed deal for Company Y’s shares at a much higher price, traders start to buy up shares and the price rises. However, there is always a chance the deal will not go through. Effectively, M&A arbitrage is a bet that a proposed merger or acquisition will go through.
Arbitrage operates as both an offensive and a defensive strategy. While you hope it returns excellent profits for you, arbitrage can also function as a “protection” and risk mitigation strategy. Making arbitrage trades can also protect you from a major loss, while giving you the opportunity to enjoy a serious profit in an upside market.
To use a real-world example, you probably have done some arbitraging and just not realized it. Here’s a classic example: at Christmas time you go to an electronics store and buy a game for your kids that costs $99. The next day, at Wal-Mart you see the same game for $89. So what do you do? You buy the $89 game at Wal-Mart and return (sell back) the $99 game to the other store for a savings (you could say an “arbitrage profit”) of $10.