Answers to 2 Questions You Should be Asking
- Why arbitrage is liked among top Wall Street investors …
- The two most frequently asked questions about arbitrage…
- The easiest way to understand the profit formulas you can use…
Dear Penny Stock Millionaire,
Yesterday I began covering the 5 most common types of arbitrage plays. Great job for sticking with me so far.
Here are the final ones you should be familiar with. I’ve also thrown in some examples to help you with your understanding.
Let’s finish up our discussion:
4. Tax Arbitrage
One of the best examples of tax arbitrage is trading in cryptocurrency. In the United States, capital gains from crypto trades are taxed. In other words, you have to pay the government a portion of your profits.
That’s not so in other countries — so-called “crypto tax havens” — like Denmark and Germany.
For example: You could buy crypto coins in the United States, then sell them in a tax-exempt country.
As long as you profit from the trade, you’d make more money than you would by selling on a U.S. exchange because you wouldn’t have to pay taxes.
5. Uncovered Interest Arbitrage
This is perhaps the riskiest form of arbitrage because it assumes you can correctly guess the future spot exchange rate in a particular country.
The idea behind uncovered interest arbitrage, which uses no hedging, involves exchanging one currency for another that has a higher deposit interest rate. That money is then invested abroad at the higher interest rate to profit.
Examples of Arbitrage
Believe it or not, arbitrage happens all around us.
If you spot a valuable record at a garage sale, buy it for a buck, and sell it for $200 to a collector, you’re participating in a form of arbitrage.
The same is true of a company that wants to reduce its labor costs. It moves part or all of its business to a foreign country with lower wage expectations. This is called global labor arbitrage — or, in more simplistic terms, offshoring.
It even happens in advertising.
Let’s say you have a website where you’ve posted a ton of content. You’re getting lots of clicks from Google search results, so you run tons of ads on every page.
You then take out ads on search engines or social media to drive traffic to your site. You’ll pay less for the clicks on your own ads than you’ll make from ads you show viewers who visit your site.
Arbitrage Profit Formula
There are several different arbitrage profit formulas you can use, but they don’t always work out the way you expect. As I mentioned earlier, there are certain forms of risks with arbitrage, including leg risk, and securities often prove unpredictable.
Just to show you how complicated it can get, take the formula investor Benjamin Graham uses to calculate the risk/reward probabilities of an arbitrage situation.
Annual Return= CG-L(100%-C)/YP
In this formula, C represents the percentage chance of success, G represents the expected gain upon success, L is the anticipated loss, Y is the holding time in years, and P is the security’s current price.
See what I mean? Complicated.
Frequently Asked Questions
I often get the next two questions when my students ask me about arbitrage:
1. Is Arbitrage Legal?
There’s nothing illegal about arbitrage. That is, as long as you’re not violating any SEC rules or using underhanded tactics that could land you in jail.
Don’t ever do that.
Not only is arbitrage legal, but it can also be helpful for overall market health. It identifies inefficiencies in a market and brings them back into alignment.
2. What Is Regulatory Arbitrage?
Think of regulatory arbitrage as the practice of exploiting loopholes in business. For example, if you know you’ll pay a lower tax rate in state than in another, you might incorporate in the favorable state.
Companies use tax havens and other regulatory loopholes to reduce their expenses. It happens daily. Most of it is perfectly legal, but you need a professional to tell you whether you’re following the law.
The Bottom Line
While I’m not a fan of arbitrage, that doesn’t mean it’s pointless.
Many of the top Wall Street traders use it frequently to maximize profits, but they’re trading millions of dollars at a time.
There’s a reason it’s beneficial for them. They have more money and better computers.
I prefer to trade in the stock market using retail-friendly strategies. My gains might not be as big as those of the major Wall Street players, but I’m comfortable with how I generate profits.