20. Arbitrage Strategy

Published at 1653228622.617

Arbitrage is a strategy that takes advantage of temporary price differences of the same asset class in two different markets. It trades and takes profits without incurring much risk. Investors implement arbitrage strategies by buying assets in a lower-priced market and simultaneously selling them in a higher-priced market.

Arbitrage strategies are closely related to efficient market theory. This theory states that the market is perfectly efficient when all past and present information regarding the asset is quickly and reasonably reflected in the market price. In other words, efficient markets will allow no opportunity to take advantage of arbitrage trading.

However, for many reasons, subjective or objective, there are  always periods of inefficiencies in the real market. That’s why the arbitrage strategy is widely used, and probably one of the oldest trading strategies in existence.

Two Main Characteristics of Arbitrage Strategies 

Only trade when there’s an imbalance in asset price. This is the most important condition of arbitrage trading, which can take several forms:

  • The same asset but being traded at different prices on two different markets; or

  • Two assets have similar future cash flow expectations but are trading at different prices.

Only trade simultaneously. The buy and sell transactions must take place at the same time. The investor may be exposed to significant risk if there is too much difference in the timing.

Arbitrage Trading in Practice

Arbitrage strategies almost don’t exist in the Vietnamese stock market. Arbitrage opportunities are more evident in the foreign exchange and cryptocurrency markets and in stocks traded over two markets, like the US and European markets.

In modern finance, arbitrage opportunities often do not exist for individual traders but only for international banks. They can continuously use and convert different foreign currencies.

An example in the modern economy of arbitrage is Bitcoin in South Korea versus the rest of the world. In 2017, the bitcoin price in South Korea was 50% higher compared to the rest of the world. Individuals/organizations who can buy and sell continuously legally may make extremely large profits without risks. However, most were unable to take advantage of this one-off opportunity although they were aware of it.

In Vietnam, the cooperation between the State Securities Commission of Vietnam (SSC) and the NYSE to develop a mechanism for investors to participate in the two stock markets was signed in May 2022. This can open up arbitrage opportunities in both markets. It is a potential project for small investors although major banks around the world dominate the field.

Barriers to Entry in Arbitrage Strategy

The development of trading systems, along with algorithmic trading leads to the extremely short occurrence of arbitrage trading opportunities. Sometimes they can last for just a few seconds. In this context, the traditional method of placing orders will find it difficult to seize the opportunity and trade on time. However, in terms of the overall market, the more the transaction speed improves, the more efficient the market will be.

Despite arbitrage trading opportunities, the price gap is also a key factor. An investor only makes a profit if the price difference can cover the trading fees and costs.