Arbitrage is when you simultaneously buy and sell the same or similar asset in a different market to profit from a small price difference. Arbitrage takes advantage of the temporary variations in the prices of the same or similar assets. Traders make a risk-free profit through arbitrage.
These variations are tracked and monitored through highly sophisticated technology. As technology improves, it has become increasingly difficult to take advantage of these pricing differences.
How does arbitrage work?
Sometimes it so happens that the same asset: a stock, commodity, or currency can be listed at different prices in two different markets. The difference may be marginal (as little as a couple of cents) as long as the price difference in the listing exists, the trader can buy the cheaper stock from one market and sell it at a higher price in the other market, thus making a profit.
Now, because the price difference is marginal, the profit is only significant if a substantial amount of money is at stake. Arbitrage traders usually work for large financial institutions because these short-lived price differences can only be detected with highly advanced software.
Why is arbitrage important in markets?
Arbitrage both takes advantage of and improves the efficiency of the financial market. This is because it pushes the prices of the lower-priced assets up and the higher-priced assets are sold off. So, the price difference between the two markets reduces and the market improves.