The word "arbitrage" gets thrown around a little bit, but here follows the pure form of arbitrage which is defined as simultaneously being "long" AND "short" a security at the same time in order to make a riskless instant profit.
First a few definitions:
LONG – Means that you believe the security is going up so you own it (or indirectly own it, to be technical).
SHORT – Means that you believe the security is going down, so you sell it. And really, shorting means you sell something you don’t own – hoping to buy it at a lower price.
Next, you’ll probably be puzzled as to why you would be long and short a security at the same time – all else being equal you expect your gain on the stock you owned would exactly be offset by the loss on the short (or vice versa) – and you would be right.
SO – the first thing you have to understand is that this strategy only applies in certain circumstances. Most often that circumstance would be when a stock is "inter-listed" – or, appears on more than one stock exchange. There are many stocks that are interlisted. For example, Pfizer is listed on the NYSE, as well as on the London stock market, Euronext and Swiss stock exchanges.
Sometimes the stocks trade at prices that are different, when factoring in the currency exchange rates etc. Now remember, these shares are all shares in Pfizer so no matter where they are traded, they represent ownership in Pfizer. So if you could buy a share in London and sell it in New York, that’s fine.
Now if you wanted to earn a "riskless profit" you do the following. Whichever exchange (after figuring the currency effects and costs for converting) has the stock priced higher than the other is the exchange on which you would SHORT the shares. At the same time you would buy the LOWER priced shares on the exchange with the lower price. You would then cover your short position by surrendering the shares you bought at a lower price from the other exchange. Simple as that.
Keep in mind any arbitrage opportunities are few and far between and you need to make sizeable transactions to really make a lot of money executing a "riskless" strategy.
For those who like examples with numbers:
Let’s say that company ABC trades on BOTH the TSX and the NYSE. It is priced at $100.00 on the TSX and $101.00 on the NYSE. The current exchange rate between the US Dollar and the Loonie is $1.02 (i.e. the Canadian dollar is stronger). To calculate the price of each stock comparing apples to apples we would need to see what the cost of each is in one currency. Let’s figure out the stock price in Candian Dollars for the NYSE listing:
$101.00 USD/share divided by $1.02 USD/CAD = $99.02 per share in Canadian dollars
Since the same share is $100.00 on the TSX there is a price mis-match. In this case we would buy shares of ABC on the NYSE at $99.02 (in CAD) and simultaneously short the shares at $100.00 on the TSX. This is an instantaneous return of 0.98% with no risk (in theory).
There are, however, some risks in practice. First you have to consider that the currency exchange rates fluctuate constantly, and if the security is liquid and highly traded, it’s price might move slightly before you can execute the orders. You would have to place limit orders, and you also have to look closely at the market depth to make sure you can match the number of shares bought and sold (and that there are willing buyers/sellers).
In addition, if you want to make any great deal of money, you’ll need large positions. Since the market IS relatively efficient, big pricing mismatches of very liquid securities ARE QUITE RARE – but they do exist.
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