What Is Arbitrage?
The same bar of gold is priced differently in two markets. Buy on one side, sell on the other, and pocket the difference, until arbitrageurs close the gap.
Risk warning: forex, CFDs, options, futures and crypto assets usually involve leverage or high volatility, and you can lose more than you put in. This lesson only teaches the concepts; all numbers are for illustration and are not investment advice.
Key takeaways
- 1Arbitrage = simultaneously buying the cheap version and selling the expensive version of the same (or an equivalent) asset to lock in the difference, without betting on direction.
- 2Risk-free arbitrage: the outcome is locked in when you open, and you can't lose whatever the price does next.
- 3Arbitrageurs' trading pushes the low price up and the high price down, squeezing the gap back within trading costs. That range is the no-arbitrage band.
Check your understanding
Get every question right to complete this lesson
1.Gold is $2,000 in market A and $2,012 in market B, with $4 of trading costs on each side. What's the net arbitrage profit per ounce?
2.Why do obvious arbitrage opportunities usually disappear quickly?
3.Which of these counts as risk-free arbitrage?
Text version · Arbitrage Strategies, lesson 1: “What Is Arbitrage?”
The same bar of gold is priced differently in two markets. Buy on one side, sell on the other, and pocket the difference, until arbitrageurs close the gap.
Buy low and sell high at the same moment
arbitrage isn't "buy low, wait for it to rise, then sell." It's buying the cheap one and selling the expensive one of the same thing at the same moment. The result is locked in when you open the trade, with no bet on price direction. That's risk-free arbitrage.
Arbitrage destroys itself
Buyers push up the low price and sellers push down the high one, so the gap keeps shrinking until it no longer covers trading costs. That's why the same thing in different markets can differ only by a no-arbitrage band: the law of one price.
All three conditions are required
True risk-free arbitrage meets all of these: filled at the same moment, buying and selling the same thing (or things exactly equivalent at expiry), with the result locked in when you open. "Buy low and wait" misses the first; pairs trading misses the third. They bet on patterns; they're not risk-free arbitrage.
Key takeaways
- Arbitrage = simultaneously buying the cheap version and selling the expensive version of the same (or an equivalent) asset to lock in the difference, without betting on direction.
- Risk-free arbitrage: the outcome is locked in when you open, and you can't lose whatever the price does next.
- Arbitrageurs' trading pushes the low price up and the high price down, squeezing the gap back within trading costs. That range is the no-arbitrage band.
Try it yourself
You can do these exercises in this lesson's interactive simulation:
- Keep costs at $4 per side and click "Run one round" once: how much does this round net per ounce? Does it match the example's "$12 − $4 − $4"?
- Keep clicking until the button grays out: how many rounds did you do in total? Why does the final gap stop within $8?
- Click "Start over," set costs to $0, then "Auto-arbitrage": how far does the gap finally shrink?
- Click "Breaking news" to make New York gold jump: does an arbitrage opportunity reappear? What if costs are $8?
Quiz and explanations
- 1. Gold is $2,000 in market A and $2,012 in market B, with $4 of trading costs on each side. What's the net arbitrage profit per ounce?
- Answer: $4.$12 gap − $4 − $4 = $4.
- 2. Why do obvious arbitrage opportunities usually disappear quickly?
- Answer: Arbitrageurs' trading pushes the low price up and the high price down.Arbitrage itself is the force that pulls prices back together.
- 3. Which of these counts as risk-free arbitrage?
- Answer: At the same moment, buying gold at $2,000 in market A and selling the same gold at $2,012 in market B.Risk-free arbitrage needs all of these: the same moment, the same (or an equivalent) asset, and an outcome locked in at the open. The others bet on price direction or statistical patterns.
Terms in this lesson
- arbitrage (Arbitrage): Simultaneously buying the cheap version and selling the expensive version of the same (or an equivalent) asset to lock in the difference.
- law of one price (Law of One Price): The same thing in different markets should have the same price once costs are taken out.
- no-arbitrage band (No-Arbitrage Band): The price range set by trading costs: when a mispricing stays inside it, arbitrage isn't profitable after costs.
- risk-free arbitrage (Riskless Arbitrage): An arbitrage whose result is locked in when you open it, so it can't lose no matter where prices go.