Confused by the term “arbitrage”? Don’t worry, we’ll define arbitrage in this article. Arbitrage is a rather advanced investing and trading method by which you simultaneously purchase and sell something, and thus lock up price differences. That probably sounds a bit odd. After all, aren’t you supposed to purchase something precisely so you can hold on to it and let it appreciate in value? Even day traders and technical analysis traders usually wait hours, minutes, or at least seconds before making a trade. With arbitrage, however, you’re buying and selling at essentially the same time.
So how does that work? After all, won’t prices be the same if you buy and sell simultaneously? Won’t you end up losing money in fees, taxes, etc? This is usually true, but while markets are always perfect within the economist’s textbook, in the real world inefficiencies are somewhat common. It is possible that an asset could be selling for less on one financial market than it is in another financial market.
Let’s take bitcoin as an example. The bitcoin market is still relatively new and not as widely used as stock markets and other financial asset markets. Bitcoin, in case you are unfamiliar, is a peer-to-peer currency. People using their computers and processing power created bitcoin. It bills itself as the world’s largest non-government currency. Most governments treat it as an asset rather than a currency.
Anyways, there are numerous bitcoin markets scattered around the world. Unlike the DJIA and the New York Stock Exchange, there is no one single big market for bitcoin. As a result, prices can sometimes vary substantially from market to market. This is especially true for global markets. Let’s say bitcoin is trading for $950 dollars on an exchange in Europe, and $1000 dollars on an exchange in the United States. If you bought the bitcoins in Europe, and then sold them in the United States, you could quickly pocket a tidy profit.
So the arbitrage definition can be taken to mean buying and selling something at pretty much the same time. By doing so, you hope to tap into price differences and inefficient markets. If markets were 100% efficient, you wouldn’t be able to make money off of arbitrage. However, since markets in reality are plagued by inefficiencies, savvy investors can produce profits.
So what is arbitrage? It’s making a profit off of the immediate purchase and sale of a single asset.
Digging into arbitrage pricing theory
Understanding arbitrage pricing theory is closely related to general arbitrage. In 1976, Stephen Ross theorized arbitrage pricing theory. This theory refers to the idea that one can determine an asset’s return by looking at common risk factors. To get a bit more technical, you can think of it as a theory that attempts to predict the relationship between how much an entire portfolio will return as well as the returns of a singular asset by compiling a large number of independent macroeconomic variables.
Quite the mouthful, right? Financial theories can be a bit complex, but the aim of arbitrage theory is to uncover miss-priced assets. Basically, you want to find something that is selling in the market for an unnaturally low price, or a price that doesn’t even represent its fundamental value. Investors use APT formulas to determine the “real” value of the assets. When you find an underpriced asset, you can then purchase it on the cheap. Then, once markets catch wind that the asset is underpriced, prices will rise!
As an investor you can then ride the upswing, wait until assets are properly priced, and then sell your assets for a profit! Of course, creating an APT formula is no easy task, and it can take years to properly define and refine an effective predictive model. Still, for many investors the best approach to investing is to find assets that are underpriced. Even Warren Buffet, arguably the greatest investor in history, uses a similar approach. His value theory is based on a similar but distinct method of looking for undervalued stocks and then purchasing them.
Even if arbitrage and arbitrage price theory don’t turn out to be the best method for you, you should consider the insights and results that these methods can produce.