What is Arbitrage?
Arbitrage: Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in the price.
Due to differences and inefficiencies in markets and exchanges, prices of assets and securities traded on these markets often are not the same.
Causes of different prices between markets are not always obvious or apparent, they usually exist due to simple supply and demand.
How to Arbitrage
Arbitrage is simple. It's just buying and selling. Without getting too specific, you buy something in one place for $1, you sell it at another place for $2. Easy money. However, there are conditions that must be met in order for arbitrage to be possible, although only one of the following is required.
- The item trades at different prices across varying markets
- The item has a sure future price, and is trading far below that.
I will use crypto currency as the basis here, I believe most of you are most interested in that. For the first listed rule lets look at Bitcoin. At the time this threads creation Bitcoin is trading at $2461 on Bitfinex, and $2448 on btc-e. One could make almost $20 by simply buying a bitcoin on BTC-E, sending it to Bitfinex, and selling it there. Of course, a $20 price difference on $2400 is only about 1%, but there are hundreds of crypto currencies traded across dozens of exchanges, find the biggest percent difference, and arbitrage.
For the second rule we can look at crashes, or more specifically, flash-crashes of coins. At this time I cannot provide a real time example but for educational purposes lets assume Ethereum flash crashes very low, $50. Since Ethereum has traded hundreds of percents higher than that, its certain that it will go back up, making it possible to triple your investment in only a few hours.
Historically, arbitrage is risk free.
In principle it is risk free, but in execution and reality it is not, but the risk is still small. There is no "risk calculator", but the longer you take to make your buy/sell trades, the higher the risk will be. Simultaneous execution is the key to arbitrage, if one can open their buy/sell order in less than one minute the chance of them profiting is almost 100%. Online arbitrage is less risky than physical arbitrage.
For the sake of education, here are some scenarios in which arbitrage can fail, and you can lose money.
Ethereum is trading at $300 on coinbase and you buy 10 coins to sell on Poloniex, where it is trading for $305. While your transaction is processing, word spreads and news releases that Vitalik has actually died. The price of Ethereum then crashes suddenly to $260 on Poloniex, and you're out $400.
You purchase potatoes in Mexico. It costs you $10000 for 10000 potatoes. You plan on driving to Nevada where potatoes are scarce and sell for $2 each, expecting a $10000 profit. However, your truck falls over in transit, and you lose all your potential potato profit. This would not happen online, and goes to show how online arbitrage is less risky.