The Trading Strategy You Should be Cautious Of
- The big reason why I’m not a fan of this strategy…
- For simultaneous buying and selling, you need THIS…
- How technology prevents these types of plays from becoming a possibility…
Dear Penny Stock Millionaire,
Arbitrage isn’t an investment strategy you should take lightly. In fact, I’m not a fan of using it at all.
In most cases, only large investment firms and hedge funds can take advantage of arbitrage. It’s a strategy that requires a ton of money to be successful, so most individual investors don’t have the cash — or the stomach — for it.
Essentially, though, just like other stock market terms, arbitrage is just a name for a tactic traders use to maximize profits.
I’ll walk you through the definition of arbitrage and how some traders use it successfully. However, I want to warn you up front that arbitrage is not without risk. In fact, it’s one of the least reliable plays you can make — and if you do use it, your trading fees can quickly swallow your profits.
Since I believe that everyone should have a basic understanding of all stock market terms, though, I’m going to give you the rundown.
What Is Arbitrage?
Let’s boil arbitrage down to its simplest parts …
In an arbitrage play, you buy something from one exchange or venue and sell it to another for a profit based on differences in the market price.
Before we jump into the stock market, let’s consider a simpler example.
For example: Let’s say you’re browsing a used bookstore.
You find a first-edition copy of a highly sought-after book stuffed in the clearance section, so you buy it for a couple bucks. Then you go to eBay and list it for $120. If someone buys it at the list price, you pocket $118.
That’s arbitrage. It’s about leveraging differences in market prices to profit.
In the stock market, you might buy shares of a stock on one exchange and sell it on another. If a stock is trading for U.S.10 on a U.S. stock exchange and U.S.8 on a foreign stock exchange, you could purchase it for $8 per share and sell it for $10 per share.
That sounds like a great deal, but it doesn’t happen often — and when it does, the difference between market prices are generally just pennies. Consequently, what you pay in transaction fees will likely outweigh any profits you make.
Additionally, arbitrage opportunities typically only last for a few seconds. Today’s technology prevents most arbitrage plays from becoming a possibility, except for major firms that track stocks in real time.
Arbitrage Economics Definition
In economics, arbitrage is defined as the simultaneous buying and selling of the same securities or other financial instruments to profit from market variations. Buying the investment and selling it in the future introduces risk to the transaction and is therefore not considered arbitrage.
For simultaneous buying and selling, you need an electronic mechanism. Otherwise, it’s almost impossible.
In fact, it is impossible because of leg risk. Since you can’t sell what you don’t have, there are two legs to an arbitrage transaction: the buying and selling of the financial instrument. Although they might only be microseconds apart, price fluctuations can occur.
This is called leg risk or execution risk. That’s why people who say that arbitrage is risk-free are either unaware of the potential dangers or choose not to disclose them.
Arbitrage in Stock Market Trading
In the stock market, arbitrage specifically refers to buying stocks or derivatives in one market and selling them simultaneously in another for a profit. As I mentioned before, though, it’s generally impractical.
I’ve never found success with arbitrage.
It’s far too complex, in my opinion.
For one thing, you must have the information necessary to determine price variations between markets. For another, you need a way to capitalize on that information by simultaneously executing trades.
How Can You Profit from Arbitrage Opportunities?
Some of the top Wall Street traders use arbitrage frequently. They have extremely expensive databases and software programs that find the opportunities for them — and, in some cases, execute the trades automatically.
If you’re sitting in your home office and learning how to trade penny stocks, you probably don’t have those kinds of assets. That’s okay. Neither do I.
When it comes to stock trading, I like to keep things simple.
I pay attention to stock charts, read up on companies that I believe might experience price movement, and execute trades based on my educated opinion. There’s no reason to throw a wrench into that winning formula and risk my money on an arbitrage play.
Those who profit from arbitrage often work on Wall Street and have access to serious computing power.
Tomorrow, let’s look at how to develop an arbitrage strategy — presuming you want to give it a try.
Either way, it’s good to know what is available to you.