Arbitrage trading is simply defined as the act of leveraging the price difference of identical or similar types of financial securities in two different markets. Arbitrageurs, who involves in arbitrage trading, buy stock in one market at lower price and simultaneously sell it into another market at higher price. Thus, making profit from a short term price difference.
Arbitrage trading aims to exploit the inefficiency of markets for trader’s advantage. Theoretically, arbitrage trading is considered as risk free. But, it is not as simple as buying a stock trading at lower price on one exchange and selling it in another market at higher price. Arbitrageurs need to eliminate execution risk or ‘leg risk’ by ideally making both the transactions occur at the same time. Other arbitrage opportunities include assets with identical cash flows trading at different prices and an asset with known future price does not trade at today’s discounted future price at the risk-free interest.
Technology advances and automated trading systems are also continuously making arbitrage trading tougher as they keep a close eye on any fluctuation and difference in prices of two different markets. Corrective actions are taken quickly in seconds to eliminate any possibility of arbitrage trading. If the market is efficient and attains the arbitrage equilibrium i.e. no price discrepancies, the market is called arbitrage-free market.
Arbitrage trading is basically a winner for traders with high trading capital and high end information gathering systems to identify and lookout for the fluctuation. Although using this method isn’t completely impossible for retail traders, it carries significant risks.
The bottom line is that arbitrage trading is a good investment method provided you have all bases covered. Even though it is risky for retail investors, it usually compensates well with the profit.