What is arbitrage? A mechanism that generates profits from market price differences

【summary】

Arbitrage is a transaction that aims to profit by taking advantage of the price difference when assets with the same or substantially the same value occur.

In theory, it seems like it's just ``buy in the low market and sell in the high market,'' but in practice, fees, spreads, execution speed, remittance time, financial strength, system failures, etc. have a big impact. It is not easy for beginners to practice consistently and make profits.

In this article, we will explain the basic mechanism of arbitrage, representative examples, advantages and disadvantages, and points that beginners tend to misunderstand. Rather than practical know-how, this is an investment education article to help you understand how the market corrects price differences.

What is arbitrage?

In the world of investing, the basic principle is "buy low and sell high."

Among these, the method of aiming for profit by taking advantage of the price difference between assets with the same value is called arbitrage.

For example, suppose the same asset is traded in two markets as follows:

In this case, the following transactions are theoretically possible:

1. Buy at A market for 1,000 yen
2. Sell for 1,010 yen on B market
3. Get the difference of 10 yen as profit

It is unique in that it does not predict future price increases, but rather uses the current price difference.

However, the 10 yen mentioned here does not necessarily translate into profit. After deducting trading commissions, spreads, taxes, transfer costs, and risk of failure, actual profits may be zero or negative.

Why does the price difference occur?

Markets are not always perfectly efficient.

The main reasons for the price difference are:

• Information gap among market participants
• Discrepancies in buying and selling timing
• Lack of liquidity
• Currency fluctuations
• Delays on exchanges and systems
• Temporary imbalance in supply and demand

In particular, when the same asset is traded on multiple markets, temporary price discrepancies may occur.

However, obvious arbitrage opportunities tend to disappear quickly, as many investors and high-speed trading systems target the price difference.

By the time a beginner notices a "price difference" on the screen, it is often no longer a viable profit opportunity.

Typical types of arbitrage

1. Arbitrage with stock indexes and futures

One of the typical arbitrage transactions used by institutional investors is trading using the price difference between a stock index and stock index futures.

for example,

• Spot stock price
• Price of stock index futures
• Theoretical price considering interest rates and dividends

If there is a discrepancy between them, a trade will be made to buy the cheaper side and sell the more expensive side.

The glossary of the Japan Exchange Group (JPX) also describes arbitrage trading as a transaction that uses the price difference between the spot price and the futures price to make a profit.

This is an area where institutional investors and high-speed trading systems are more likely to take center stage, rather than individual investors entering manually.

2. ETF and NAV arbitrage

ETFs have a theoretical value based on their constituent stocks and indexes.

For example, if the ETF price rises above its original value, the following transactions could theoretically occur:

• Sell expensive ETFs
• Buy component stocks and index-linked parts

On the other hand, if an ETF becomes undervalued, a transaction of buying the ETF and selling the constituent assets will be considered.

This arbitrage mechanism makes it difficult for ETF prices to deviate significantly from their base price or underlying index. This is one of the reasons why the ETF market functions relatively efficiently.

However, it is not easy for individual investors to make this arbitrage directly. In practice, professional market participants, such as designated participants and market makers, play an important role.

3. Foreign exchange arbitrage

Currency arbitrage is a transaction that takes advantage of distortions in exchange rates between multiple currencies.

for example,

円 -> ドル
ドル -> ユーロ
ユーロ -> 円

If there is a price discrepancy through this exchange route and the original yen ultimately increases, theoretically a profit will occur.

However, currently, banks, major financial institutions, and algorithmic trading systems are constantly monitoring it, so there are few opportunities for individuals to discover it in a visible and stable manner.

4. Crypto asset arbitrage

In the crypto asset market, you may see price differences between exchanges.

example:

In this case, the price difference is 200,000 yen.

Although appealing at first glance, in practice the following costs and constraints must be reviewed:

• Trading fee
• Spread
• Transfer time *Withdrawal restrictions
• Price fluctuation
• Exchange risk *Tax treatment

In particular, the price of crypto assets is subject to large fluctuations, and price differences may disappear during remittance. It is dangerous to think that you can make money easily just by looking at the price difference.

Advantages of arbitrage

The basis of profit is relatively clear

Arbitrage focuses on current price differences rather than future predictions.

Rather than reading whether stock prices will rise or fall, the idea is to find discrepancies between stocks with the same value.

Less dependent on market direction

Normal stock investing requires the price to rise after you buy.

On the other hand, arbitrage trading involves buying cheap items and selling expensive items, so in theory it is less dependent on the rise or fall of the overall market price.

Contributing to market efficiency

Arbitrage acts to bridge price differences in the market.

Buying occurs in undervalued markets, and selling occurs in overvalued markets, making it easier for the price to approach the theoretical value. This is an important mechanism that supports the price discovery function of the market.

Disadvantages of arbitrage

Easy to lose fees

The price difference targeted by arbitrage trading is often small.

Therefore, the apparent profit may disappear after buying and selling commissions, spreads, taxes, and transfer costs are deducted.

Easy to become a speed competition

AI and high-speed trading systems can quickly target easy-to-understand price differences.

In some cases, the price difference has already disappeared by the time an individual investor looks at his or her smartphone screen and places an order.

Capital efficiency tends to be low

The profit margin per arbitrage transaction is often small, so it tends to require a large amount of capital to make a large profit.

The amount of funds, transaction costs, and execution speed greatly affect the results.

Not zero risk

Although arbitrage is sometimes described as "low risk," there are risks in practice.

for example,

• The order is executed on only one side
• Price difference disappears during remittance
• System failure occurs
• Subject to exchange withdrawal restrictions
• Loss caused by rapid price fluctuations

Such is the case.

Theoretical profits and actual profits are two different things.

Points that beginners tend to misunderstand

Beginners should especially note that there is a difference between "discovering a price difference" and "being able to lock in a profit."

The price difference on the screen may already have cost and risk factored in.

What investors should learn from arbitrage

Even if you don't practice arbitrage, it's worth learning how to think.

This is because by understanding arbitrage, it becomes easier to see the essence of investment, such as the following.

• Market prices are always subject to correction
• Easy-to-understand discounts are difficult to ignore
• There is a reason for the large price difference
• Price differences tend to remain in markets with low liquidity.
• Profit calculations that ignore transaction costs are dangerous

This is also important for long-term investors.

This is an entry point for thinking about `Why are undervalued stocks corrected someday?'' Why are some stocks abandoned even though they appear to be undervalued?'' `Why do we need to be careful about illiquid products?''

Arbitrage is not only a short-term buying and selling technique, but also a teaching tool for understanding how the market works.

summary

Arbitrage is a method of making profits by taking advantage of price differences in the market.

Although it seems low risk in theory, in reality there are commissions, spreads, execution speed, financial strength, system failures, and price fluctuation risks, making it difficult for individual investors to consistently make profits.

For beginners, it is more practical to use arbitrage as knowledge to learn about `how the market forms prices and corrects distortions'' rather than viewing it as `a way to make quick money''.

When it comes to investing, what's left after deducting costs is more important than the apparent price difference. Just being able to understand this will make a huge difference in the accuracy of your investment decisions.

source

• Japan Exchange Group “Glossary: Arbitrage”
• Japan Exchange Group “Trading Methods｜Futures/Options”
• Japan Exchange Group “Trading (ETFs)”