Arbitrage : Risk Management With Arbitrage Opportunities in today's world

 What is arbitrage? 

Arbitrage happens when a particular security is bought at one point in time at low prices and then sold at another point at higher prices. 

The temporary difference of the value of the same security between the two points allows savvy investors to lock in profits by buying at low prices and selling at high prices. 

This allows the investor to buy at a low price and sell at a high price, thus maximizing the profit. This can be profitable only if the investor has some understanding of what goes into arbitrage.


How are block trades different from arbitrage? 

Block trades involve short selling or short buying a particular security that has been previously purchased at a lower price.

Block trades are used to make money in volatile market conditions where prices go up and down very fast. 

Traders use an option to purchase a security whose price has dropped from its initial purchase price, and then they sell it back at a slightly higher price as per the option contract. They hope that if the price goes up they would be able to resell their option at a higher price than their original option purchase price.

The most common form of arbitrage opportunity

The most common form of arbitrage opportunity is in the commodities market. Commodities trade on specific market times. 

During market open, a commodity is bought from suppliers at a specific price and later sold at a specific price. It is then possible to make a profit by buying a commodity that has gone one way already. This can happen during off peak hours or when the demand for the commodity increases.

How are shorting and longing opportunities different?

Shorting in the commodities market occurs when an investor borrows from a lender at a specific rate of interest. If later the investor decides to sell his assets, he owes the lender the difference between his loan balance and the market price of his asset. 

On the other hand, when an investor decides to buy a security with a lower price than its fair market value, he has borrowed from a lender at a fixed rate of interest and later resells the security at a higher price, making a profit. 

While there is generally some level of risk involved, shorting, and longing opportunities have the potential to be very profitable for investors. 

There are instances when investors make hundreds of thousands of dollars just within hours of buying and selling one stock.

Arbitrage opportunities are based on what ?

Arbitrage opportunities are based on high risk-free transactions. Any time an investor enters into such a transaction, there is a risk of losing money. 

This is because any price difference that results from buying and selling a security could cause the investor to incur a loss. Thus, before making an investment decision, investors need to weigh the expected profit from the transaction against the potential risk.

Arbitrage lets traders take advantage of differences in prices

Arbitrage lets traders take advantage of differences in prices between different markets. It can be done using the foreign exchange or equities market. 

This involves the purchase of a certain amount of currency from one foreign exchange market and the sale of another amount of currency from another foreign exchange market. 

This allows people to gain exposure to different markets without incurring too much of a financial risk. For example, by buying currency A when it is cheaper than currency B, an investor can use arbitrage to make profits on the sale while buying currency A at its higher price.

However, this form of arbitrage is considered risky by many people. Since currency prices vary significantly between different markets, arbitrage can be a dangerous venture if investors do not carefully manage their trading activities.

For instance, since forex arbitrage offers the convenience of conducting trades across different exchanges, people might be tempted to frequently enter and exit trades. This leads to severe transaction costs, which in turn reduces the profitability of arbitrage trading. 

Worse, since the transaction costs often outweigh the profits, arbitrage strategies might result in losses.

How to minimise risk in share market ?

To minimize risk, it is advisable for people to consider only buying and selling transactions that come with a price difference. 

For instance, a trader could purchase shares of Microsoft Corporation from a Nasdaq stock exchange in the US and sell those shares on an NYSE stock exchange in the UK. 

While the transaction costs are lower, the profit made would still be less than the cost of purchasing and selling the shares directly. 

Disclaimer : 

By buying and selling only between different markets, a trader reduces the risks associated with arbitrage opportunities and maximizes his or her profit potential. 

This is because arbitrage is an activity that is best employed in situations in which the price difference is minimal and transactions have minimal transaction costs.

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