Arbitrage is a type of financial concept that reflects cases where an investor can earn a risk-free excess profit, sometimes by simultaneously buying and selling the same asset at different prices.

Traditionally, in financial markets, it is widely professed that "there is no free lunch". What this means is that while some investor positions will invariably earn profits, no earned profits were free; they were earned through some incursion of risk.

The term arbitrage refers to rare situations where riskless profits are available. In such cases, excess profits are essentially guaranteed, without being exposed to risks. True arbitrage opportunities often exist only for a short period of time, as market participants recognize the price dislocation and eliminate it through trading.

What's An Efficient Market?

The idea of arbitrage relies on the theory of efficient markets. The efficient market hypothesis states that markets correctly price in all available information. Investors collectively act as rational economic participants, arriving at the correct price for assets based on all the knowledge that is collectively known at the given time. When new information arrives, efficient markets factor it into the price almost immediately.

Because arbitrage is generally seeking to exploit fractional short-lived pricing discrepancies, arbitrage opportunities cease to exist once markets return to rational pricing. In most cases, markets are reasonably efficient and a true arbitrage position will result in a pay-off for traders in just a short period of time.

How Arbitrage Works

Arbitrage traders typically monitor the prices of assets across numerous different markets. When the price of an asset moves a little bit out of sync with its price in other markets, a trader can, to put it most simply, step in and buy the cheaper version of the financial instrument while simultaneously selling the more expensive version, netting a profit. This locks in a nearly "risk-free " profit if done correctly. There can be transaction costs, borrowing fees, shipping expenses, and so on. But if the price differential is sufficient after these expenses to make a profit, the arbitrager will usually proceed with the transaction.