Definition

Arbitrage occurs when an investor can make a profit from simultaneously buying and selling a commodity in two different markets.

How it works?

The markets are regulated with the arbitrage mechanism and aid in smoothing out price differences to ensure that securities continue to trade at a fair market value.

It has become extremely difficult to profit from mis-pricing in the market with the advancement in technology . Many traders have automated trading systems for constant monitoring fluctuations in similar financial instruments. Any inefficiency in the pricing setups are noticed and acted upon quickly and the opportunity is often eliminated in a matter of seconds.

Specification:

Arbitrage is a trading strategy about buying in one market and simultaneously selling in another, profiting from a temporary difference. This is considered risk-less profit for the investor/trader.

In the context of the stock market, traders often try to exploit arbitrage opportunities for profit maximization. Its a practice of trading on price difference between more than one market for the same security in an attempt to profit from the imbalance. There must be a situation or a scenario of at least two equivalent assets with differing prices.

For example, on a foreign exchange where the price has not yet adjusted for the constantly fluctuating exchange rate a trader may buy a stock to take the competitive advantage.

The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange, and the trader usually makes a profit from this difference.