How Arbitrage Works

Traders react to a sell-off on the Tokyo Stock Exchange. Shares plunged partly because of arbitrage selling.

TOSHIFUMI KITAMURA/AFP/Getty Images

In the world financial community, arbitrage refers to two basic types of activities. One requires little or no risk on the part of the investor, and the other can be highly speculative.

In its purest form, arbitrage contains no element of risk. True arbitrage is a trading strategy that requires no investment of capital, can't lose money, and the odds favor it making money. Any transaction or portfolio that's risk-free and makes a profit is also considered arbitrage [source: Riskglossary].

But pure arbitrage actually quite rare. Why? Financial markets are set up in a way that discourages arbitrage from happening in the first place. Markets are designed so that securities are priced equally within all trading markets. They're said to be arbitrage-free.

Occasionally, minor price differences occur on financial markets. These price differences, called mispricings, mean that there's a temporary discrepancy between a stock's intrinsic value and its market value. A quick-moving trader can take advantage of such opportunities and make a profit. For example, a share of Microsoft may sell for $28.00 in the U.S. market and sell for $27.98 on one of the European exchanges. Such a difference may exist for a short time because exchange rates haven't been applied yet. If a trader makes a trade before the price is adjusted, he or she can make a profit of two cents per share. If enough shares are involved, this profit can be considerable.

If you watch the financial television channels such as CNBC and Fox Business News, or read financial blogs, newspapers or magazines, you'll hear a lot about arbitrage. Most of the time, however, the discussion won't revolve around true arbitrage. It'll revolve around speculative arbitrage -- which involves speculative trading strategies -- and transactions by hedge funds, the often mysterious and much-maligned investment partnerships between well-to-do investors.

To learn more about arbitrage, trading and related topics, follow the links on the next page.