Arbitrage Trading Explained

Arbitrage traders look for a disparity in price and value and profit from the difference. The price/value disparity can be in a particular stock, index, commodity, buyout, merger, etc. Unfortunately, as our technology advances, arbitrage opportunities continue to slip away and become less common. These days with advanced computing, any disparity in price and value is quickly corrected, often times before an investor is able to capitalize on the situation.

The only real arbitrage trading situation that comes up every so often is between stock indices and futures. For instance, S&P 500 index could be down 10 points while the S&P 500 futures are only down 5 points. Since these securities match each other, there is currently a 5 point disparity that will eventually be corrected. Typically, this when a trader will sell the stock and buy the future. That way you are locking in that 5 point disparity while buying the future to gain that 5 point disparity. Keep in mind that these corrections tend to happen pretty quickly and if you are too slow to the punch, it could cost you.

Since arbitrage trading has changed and become more difficult, I do not recommend it for new traders as it is faster paced and difficult to catch those gains if you are inexperienced. Furthermore, as I stated earlier, advancing computer technologies make it difficult and leaves you with no room for error. This is why arbitrage trading can be damaging for new traders. Not to mention, most arbitrage trades are for only a small price/value infraction and usually does not yield high enough gains for a beginner to bother. A large trading account is needed to make any meaningful money with this strategy.

If you are still interested in arbitrage trading, I recommend getting educated and practicing before you risk your own capital. This is another example of why paper trading accounts are so important. If you fail to properly learn the tactics involved, the speed at which you must place trades and the confidence to place trades, you could be putting yourself at an unnecessary disadvantage. Another tool that could be of some use are arbitrage calculators. These will help you better identify opportunities and where to place trades. However, these calculators have been known to be wrong from time to time because of the fast paced correcting and market price action movement.

Similarly, there is software available on the web that boasts of successful arbitrage trading. Yet, most software only works in one kind of market condition and not reliable on a regular basis. Furthermore, these companies often charge a pretty penny for access to the software, adding to your cost, which makes it harder to realize gains.

The only situations that are somewhat still available from a arbitrage standpoint are merger or buyout related. Company A plans on buying Company B at $20 a share. Currently, company B is trading at $15, that is a $5 disparity between the acquisition price and current price. However, if company B does not jump to $20, often times company A will lower the bid or find some way to close the price/value discrepancy.

The bottom line here is that arbitrage trading is extremely difficult in this day in age. Technological improvements make it especially difficult as companies and other financial entities try to close the gaps. Furthermore, trading is fast paced and leaves little room for error. Again, this is not a recommended strategy for beginners as it requires a lot of discipline and knowledge of the situations. If you still wish to try arbitrage trading, get educated and practice on a paper account before adventuring out with your real money.