Do you want to know how traders lock in profits? Well, arbitrage is a risk-free strategy that many traders use when it comes to foreign exchange investments.
Although the word arbitrage itself sounds fancy, the idea behind it is straightforward. In short, traders make risk-free profits by merely taking advantage of differences in price.
However, to be able to lock in gains, you must know first precisely what arbitrage stands for and how you can find arbitrage opportunities. So, if you want to know the answers to these questions, keep on reading.
What is Arbitrage Opportunity?
Let’s begin by explaining what arbitrage is with a simple example. Say you want to buy oranges from a market that’s in one part of your town, where one orange costs $1.50.
However, in another market across your town, the same type of orange costs $2.50. In this case, we will assume that the oranges are entirely identical. Now you are probably wondering what has arbitrage to do with oranges. Allow us to explain.
So far, you have discovered a product that has a different price in two markets. Will you take advantage of the opportunity to make money?
If yes, then you should buy the orange that costs $1.50 and resell it on the more expensive market for $2.50. In this case, with one orange, you would make a $1.00 profit. Imagine what will happen if you initially buy 100 oranges.
Simply said, arbitrage is an excellent easy-to-execute strategy. When it comes to foreign exchange investments, arbitrage is when you buy a security, commodity, or currency in one market and then sell it immediately in another market for a higher price, thus making an immediate risk-free profit.
To be precise, stock exchange traders purchase stocks on foreign exchanges where the equity’s share price has not yet adjusted for the exchange rate. By doing so, they exploit the arbitrage opportunity.
Furthermore, it is essential to note that due to the digitization in all aspects of the world, profits from risk-free arbitrage are becoming lower and lower. So, if your goal is to make significant gains, you would probably have to invest a large amount.
Example: How to Find Arbitrage Opportunity on Crypto Exchanges
In this example, we will focus on finding arbitrage opportunities on cryptocurrency exchanges. Let’s say that on Exchange A, you can buy Ethereum for $1.0. Meanwhile, ETH is being traded for $1.10 on Exchange B. Here’s how you can profit from arbitrage.
In short, you could buy Ethereum through Exchange A then transfer if to Exchange B. From these actions, you will benefit by 10%. Or, in other words, this action will enable you to profit from the temporary difference in price.
Further, if you want to accumulate higher gains, you could repeat the process several times or with a higher initial amount.
However, nowadays, there are hundreds of currency pairs at each exchange. Moreover, it would be nearly impossible to have multiple screens open at the same time so you could watch prices.
Not only this, but as digitization is a part of every aspect of the world, it would be nearly impossible to take advantage of discrepancies manually. Typically, softwares detect any deviation in price and correct it within seconds.
Although digitization might be a problem, and it seems like a complicated transaction, experienced arbitrage traders can notice those small windows and take advantage of this opportunity. But for inexperienced traders, it would be challenging.
Beware of Transaction Costs
When taking advantage of arbitrage opportunities, there are some things you should consider first. For instance, due to digitization, profits from risk-free arbitrage are becoming lower and lower.
Further, you should also beware of transaction costs. Make sure you take them into account because translation costs have the potential to neutralize the gains from any arbitrage trade.
Also, arbitrage opportunities will continue to exist as long as there is a difference in price. However, if all markets become perfectly efficient, there would no longer be any arbitrage opportunities.
Lucky for arbitrage traders, markets are rarely perfect, which gives them numerous opportunities to capitalize on pricing discrepancies.