Reviewed by Aug 27, 2020| Updated on
Market arbitrage refers to the purchasing and selling in the same security in different markets at the same time to take advantage of a price gap between the two separate markets. By definition, arbitrage is the manipulation of price differences in different locations on the same asset to achieve a riskless benefit.
The arbitrage is possible only because markets are not completely effective, contrary to common opinion. An arbitrator would sell the security that is priced higher in one market in a market arbitrage trade while at the same time buying the same security in the market where it is priced lower. The benefit is the difference between the price of the commodity in both markets.
Market arbitration can only be a viable practice if an asset, which is traded globally, in different markets, is priced differently. By principle, the same asset prices should be standardized across all stock exchanges but, by fact, this is not always the case. This lack of uniformity brings in incentives for business arbitrage.
Market arbitrage is, in principle, considered a risk-free operation because at the same time traders essentially buy and sell equal quantities of the same commodity. Again, the fact is that while the notion of riskless benefit is usually true, in the offsetting markets, the arbitrator assumes the risk of price fluctuations. The price of a security in the offsetting the market may rise surprisingly and result in a loss for an arbitrageur.
Market Arbitrage Practices
Market arbitrage opportunities are limited and short-lived, as security rates change according to supply and demand powers. The process of arbitration, in and of itself, would remove the possibility of arbitration in the short term.
Taking advantage of market arbitrage opportunities requires considerable resources, which is why institutional investors and hedge funds are capable of taking advantage of market arbitration opportunities. Spreads between unfairly priced securities are generally just a few cents.