Arbitrage is when people make money by exploiting a market inconsistency. Arbitrages can be very simple, or very complicated.
An eggcellent idea?
Say you live in a small farming town that has a wholesale market where people buy and sell their farm produce.
Your neighbor has chickens, and tells you he’s been selling his eggs at the market for a dollar a dozen.
But you spend lots of time at the market, so you know many buyers pay $1.50 per dozen, which is what you sell your own eggs for.
Based on this knowledge, you offer your neighbor $1.25 per dozen for his eggs, so you can sell them at market for $1.50 and make a quarter from every carton. Your neighbor loves this idea too, because he makes more than he did before.
This is an arbitrage opportunity. It exists because of an information ‘asymmetry:’ not everyone has the same market pricing information.
Your egg arbitrage will work for a while until your neighbor figures it out. Eventually he’ll find the buyer paying $1.50 per dozen, or they’ll find him, and cut you out of the deal.
Most arbitrage opportunities are more complex, because people figure out simple mispricings quickly, so they don’t last long. Arbitrage is often done by computerized trading programs which can spot market inconsistencies and pounce on them rapidly.
Some common areas for arbitrage are:
- Currency trading. There are many currencies in the world, and exchange rates fluctuate constantly. So it’s a ripe area for finding mismatches.
- Sports betting. People bet on lots of races and games, and the odds are constantly fluctuating.
- Labor markets. Global labor costs are always going up and down, and some corporations do ‘labor arbitrage,’ constantly shifting work to take advantage of these fluctuations.
- Internet marketing. Today’s ad networks are complex and competitive with constantly changing prices. It’s easy to buy and resell inventory when you spot an arbitrage opportunity.
But arbitrage isn’t limited to these areas, there are many others.
Arbitrage doesn’t actually create value – you’re not making or building anything. All is does is to make markets operate faster and more efficiently.