What is Arbitrage Trading? – Tutorial & Guide

Arbitrage can be classified into different categories such as asset classes, markets (spot market or futures market) or strategies. In principle, however, in my opinion they are all similar and can therefore always be classified into one of the three following categories:

Safe arbitrage, where the arbitrage profit can be realized without risk and where additionally more is earned than the risk-free interest rate.

Limited Safe Arbitrage, where you have two assets that have one or almost the same cash flow and are trading at different prices. However, there is no guarantee that the prices will actually converge, so the risk is limited.
Speculative arbitrage, which at first glance does not appear to be real arbitrage. Here, traders try to gain an advantage by recognizing an “incorrect” valuation in mostly similar assets. This involves buying the supposedly undervalued asset and selling the overvalued asset.

Safe Arbitrage

Many types of secure arbitrage are not visible to the naked eye for the normal trader. Therefore, most traders use mathematical computer programs and/or have trading fully automated. In addition, these secure arbitrage options often only exist in very small time frames, so that a manual trader is usually even too slow for this.

Such a type of arbitrage is, for example, index arbitrage, as I have already described it superficially in the last article “Fair Value”.

Safe arbitrage is now rare (compared to the other forms of arbitrage), and it is mostly found in the futures and options markets.

Limited secure arbitrage

To illustrate the whole thing, I have included an example.

We are looking at a share that is listed on two different stock exchanges. In this example, this share is tradable on the Frankfurt and Paris stock exchanges. Especially with shares that are listed in Germany and abroad, there are often price differences.

Bid-ask price of share XYZ on the Frankfurt stock exchange

 Bid volBid rateAsk courseAsk Vol

Bid price of the XYZ share on the Paris stock exchange

 Bid volBid rateAsk courseAsk Vol

A limited risk here is that the price difference between the two shares may suddenly narrow, or that the price may change, or that the volume on the opposite side may decrease, so that a hedge is no longer so easily possible

What can you see when you look at the two bid-ask prices ?

The XYZ share is quoted at 210.40 – 210.50 in Frankfurt and 210.85 – 210.95 on the Paris stock exchange.

This means that the share is quoted in Paris about 35 cents too high (in relation to the share on the Frankfurt Stock Exchange). So you can sell the share at the stock exchange where it is quoted too high (in this example in Paris). Immediately afterward, you buy the stock at the stock exchange where it is listed lower (in this example in Frankfurt).

In this example, an arbitrageur would sell 528 shares at €210.85 and then buy them back in Frankfurt at €210.50. Since the opposite side of the trade (in the Frankfurt example) has only 528 shares on the bid side (Ask), the arbitrageur sells only 528 shares in Paris and does not serve the ask side (Bid) completely with the 540 shares.

How much would the profit be without considering transaction costs, etc. ?

Sale of 528 shares at 210.85 € and purchase at 210.50 €, which corresponds to a profit of 0.35 € per share. With 528 shares, this would be a profit of 184.80 €. Or expressed as a percentage: One achieves a return of approx. 0.17 percent on the capital employed (184.80 €/ 528 shares * 210.85 €).

Such situations do not arise very often, of course, and perhaps only 0.20 € per share or less can be earned, but even that adds up at the end of the day. In addition, the professional arbitrage houses also have correspondingly very good conditions and comparatively low transaction costs. For the private trader this would not be feasible, if only because of the high transaction costs. Nowadays, a great deal is also implemented with the help of algorithms, and markets are scanned or automatically traded accordingly. Here too, private traders lack the infrastructure and know-how.

American Depositary Receipt
It is perhaps also interesting to note that arbitrage gains can be made on equities, even if they are not directly listed on a foreign stock exchange.

How can this work?

You can also trade ADRs (American Depositary Receipt) on many shares.

ADRs are similar to certificates and are issued by US credit institutions. They often represent a fraction of the share, but can also be equivalent to a full share. The advantage is that foreign shares can be traded in the USA quite easily. They can be traded like ordinary shares and the issuing credit institution determines the ratio of the ADRs. A ratio of 10 means that 10 ADRs correspond to one share.

Maybe it is interesting to know that ADRs can be divided into 3 different types:

  • Level 1, is the simplest type of ADR. Here, the ADRs are not listed on the stock exchange, because the foreign company either does not qualify or does not want to do so. They are therefore traded OTC (over-the-counter), i.e. off-exchange. It is therefore the simplest and most cost-effective way.
  • Level 2, these are traded accordingly on the stock exchange and therefore have slightly more requirements from the SEC (Securities and Exchanges Commission). However, this also leads to a significantly higher trading volume of ADRs.
  • Level 3, this is achieved when a company places new shares in the US capital market, thus enabling it to raise capital. Here, the attention of the markets, and thus the trading volume, is naturally highest in the USA.

Example of limited secure arbitrage with ADRs

So we now come to a small example, which would also be a limited safe arbitrage (“limited safe”, since this type of arbitrage is always associated with some risk).

Let’s assume that ABC, a German company, wants to trade its shares in the USA and has ADRs issued by an American bank. The bank sets a ratio of 10:1. This means that 10 ADRs correspond to one share. The ADRs are currently quoted at $22, i.e. the share would have to be quoted at $220 after conversion from EUR to USD, so that it would be traded at its “fair” value. However, if the stock is now quoted at $219.50, for example, after converting the currency, you can try to make an arbitrage profit. You borrow the ADR and sell it at $220, and at the same time buy the ABC share at €199.54 (equivalent to $219.50 at an assumed exchange rate of 1.10). This would result in a profit (without including transaction costs) of $0.50 per share. Since the transaction costs of ADRs are usually higher than those of normal stock trading, it is only worth arbitrating them if the price difference is large enough.

Speculative Arbitrage

One form of speculative arbitrage is spread trading (also known as pairs trading). However, this can also be seen as an independent strategy. But for me it is nothing else but a form of speculative arbitrage.

It is an attempt to profit from the correlation or ratio of two different values. This form of arbitrage can be used in all markets and instruments.

In other words, you bet that the correlation or ratio of two market values will increase or decrease. For example, you can trade preference shares for ordinary shares (e.g. Volkswagen Spread). You sell the share that is quoted at a higher price and buy the one that is quoted at a lower price. However, it is important to look at the historical spread and, if possible, only enter into this spread in the event of rather untypically large price differences (or highs/lows). Futures can also be traded against each other (e.g. Crude Oil and WTI). It is also possible to trade stocks that come from the same sector, such as E.ON and RWE. There are no limits here and there are really countless possibilities. You look at markets, stocks, etc., which usually correlate with each other or are historically similar, and try to profit from larger deviations.

There are also many exotic spreads that hardly correlate with each other and are traded nevertheless.

In any case, it may well be interesting for the private trader to deal with the topic of spread trading. Many brokers also offer corresponding discounts on the margin for spread trading in the future market. These discounts can be between 25%-75%. Especially for private traders who are not so well-capitalized, this can be an advantage. You are also independent of the market direction, and the risk is usually smaller with spread trading.

Bottom line:

There is a multitude of possibilities and strategies for professional or institutional stock exchange traders to make money in stock exchange trading. One form is arbitrage. For private traders, however, it is almost impossible to make money in the field of arbitrage due to transaction costs, infrastructure, and know-how. The only form of arbitrage that can also be very interesting for the private trader is speculative arbitrage in the form of spread trading.

Concluding remark:

In my opinion, however, a private trader should concentrate on price action trading, because here he has exactly the same conditions as professional or institutional stock exchange traders.

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