Arbitrage is a trading strategy that has saxo bank forex leverage calculator billions of dollars as well as being responsible for some of the biggest financial collapses of all time. What is this important technique and how does it work?
That is what I will attempt to explain in this piece. An Excel calculator is provided below so that you can try out the examples in this article. Arbitrage and Value Trading Are Not the Same Arbitrage is the technique of exploiting inefficiencies in asset pricing. When one market is undervalued and one overvalued, the arbitrageur creates a system of trades that will force a profit out of the anomaly. In understanding this strategy, it is essential to differentiate between arbitrage and trading on valuation. Buying an undervalued asset or selling an overvalued one is value trading. The true arbitrage trader does not take any market risk.
He structures a set of trades that will guarantee a riskless profit, whatever the market does afterwards. Arbitrage Example Take this simple example. Suppose an identical security trades in two different places, London and Tokyo. For simplicity, let’s say it’s a stock, but it doesn’t really matter.
The table below shows a snapshot of the price quotes from the two sources. At each tick, we see a price quoted from each one. At 8:05:02 the arbitrageur sees that there is a divergence between the two quotes. London is quoting a higher price, and Tokyo the lower price. At that time, the trader enters two orders, one to buy and one to sell. He sells the high quote and buys the low quote.
Because the arbitrageur has bought and sold the same amount of the same security, theoretically he does not have any market risk. He has locked-in a price discrepancy, which he hopes to unwind to realize a riskless profit. Now he will wait for the prices to come back into sync and close the two trades. Not a huge profit, but it took just three seconds and did not involve any price risk. This is why you have either to do it big or do it often.