Arbitrage
Arbitrage is the act of finding an imbalance in market prices and taking advantage of it for an immediate profit. This happens when the price of an item differs from market to market. An example in today’s market would be buying a Play Station 3 for $600 at Wal-Mart, and then turning around and selling it for $2,000 on eBay.
Arbitrage can occur in any market, whether it be stocks, bonds, currencies, or commodities. In the stock market, arbitrage is very rare. When it does occur, it is short-lived. This is because of a phenomenon known as convergence. Prices in different markets tend to gravitate towards an equilibrium price because of the demand created by acts of both voluntary and involuntary arbitrage. Simple economics explains that the more in demand a product is, the higher its price will go. Naturally, smart consumers are going to take advantage of a low price in one market until sellers realize they can charge more. Sellers in the other, more expensive, market will be forced to lower their prices at the same time. Eventually, prices will converge in the middle.
The risk associated with arbitrage is fairly low. Since trades are almost immediate, the prices of financial instruments being traded are not going to fluctuate much. If money is lost in trades, it will be lost in small percentages. However, there is a big addendum to this risk. In cases of arbitrage, the amount of money being negotiated with is usually very large since price differentiation is never great. This means that a change of a few percentage points, after transaction fees, can add up to be quite a hefty sum. The use of margin accounts when trading only amplifies this risk since leverage increases the amount of money at risk.
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