How Firms Increase Profit During Arbitrage Opportunities
According to the New York Securities exchange’s magazine, Arbitrage is a strategy in both the forex and the stocks market. It involves buying a security or a currency in one exchange market or a forex broker and simultaneously selling the same security in another exchange at a value higher than the price one purchased it. In this case, the profit the traders make is the difference between the two, most traders consider this a risk-free profit for the trader, but this is rarely the case for average retail traders.
Looked at from the stock market’s point of view, most retail traders frequently attempt to take advantage of the arbitrage opportunities. But this does not always end well for average retail traders. For instance, a good trader could buy a shares on a foreign exchange waiting for price to be adjusted. In this case, the value of the share stock on that particular foreign exchange is thus undervalued when put parallel to the value of the same share stock on the local exchange. It is when there is such a difference that the trader makes money. Basically, arbitrage is a trading strategy where a trader makes profit in the small differences of similar or identical assets. Market inefficiencies can create short term discrepancies in asset value; and reveal profit opportunities for traders. There are two main type of arbitrage Pure Arbitrage and Risk Arbitrage (Australian Securities Exchange, 2015). Examples of Arbitrage include;
1. Pure arbitrage
This is risk free arbitrage. An example of a pure arbitrage includes the MegaFon stock traders on the NYSE with its corresponding futures contract trading on the Chicago exchange. If one were to become suddenly cheaper than the other, a retail trader could simultaneously short the more expensive of the two and long the cheaper. Like in this case, if the stock on both exchange markets trade at $650 at the start, then the stock of the same contract at NYSE suddenly slips to $655, while the other slides slightly below $650 to $645, then a trader could sell the more expensive stock at the NYSE and buy the cheaper contract at Chicago. Thereby profiting from the difference (655-645), a profit of $10. This kind of arrangement makes it sound simple, but the average retail trader is unlikely to find such an opportunity since the market makers frequently use automatic systems that automatically notice such differences and take advantage of them almost instantly. However, there are opportunities for retail traders to take part in risk arbitrage (Jarecki et al., 2015).
2. Risk Arbitrage
This type of arbitrage is considered speculative and in most cases very risk averse specially to retail traders. This is simply because it based on presumption about future events not proven facts. Example of Risk Arbitrage includes a scenario where Tom, learns that JPMogan Chase Company wants to buy CDC breweries. Shares of CDC breweries is currently trading at USD 75, while JPMOgan Chase Company plans to buy the same shares at USD 100 each. Tom then decides to buy 100 shares of CDC breweries for USD 7,500 and hopes to sell them at USD 10,000 after the takeover. Making a solid profit of USD 2,500.
If the various exchanges were working perfectly well, arbitrage opportunities would never exist anywhere, but market is always imperfect. Everything can be put in place, include systems and laws but the market can never be perfect. Thus, it is vital to recognize that even with the local markets discrepancy in pricing always occur among similar goods. Arbitrage can be good for the market makers, but sometimes it’s actually an expense. This is how companies and firms deal with negative arbitrage.
How Firms handle Arbitrage
Algorithmic trading; other than the Expert advisers, scripts and indicators used by retail traders to monitor and trade through various platforms, such MT4, trader stations, JForex and over the counters, Brokers especially market makers have come up with their own algorithmic systems to help monitor every abnormality in market. These algorithmic systems are very fast and can identify such abnormalities in microseconds, way faster than any human being. For instant, assuming between two exchanges, New Stocks Exchange, and Australia Exchange Securities, a Broker has excess to real time prices of two exchanges. The broker can come up with an algorithmic program that monitors discrepancies amongst the shares. For example, a System is programed to monitor the prices of FedEx in both exchanges. Currently, the price of FedEx on both exchanges is USD 192, then suddenly the price at NYSE rises to USD while the price at AES declines to 185.00. This differences is an opportunity for the broker to make money from the investor, and to achieve this, the program identifies this abnormality in microseconds and Automatically buys the share at AES and sell it at the NYSE therefore making money before the investor even has time to do the opposite (Björk, 2009).
Varying spreads through Bid and the ask price. This is very common with the Forex Arbitrage trading. Bid price is the selling price, while the Ask price is the Buy price. The difference between Ask and Bid price is known as the spread (New York Stock Exchange, 2018). Most cases, in case of such abnormalities in the market, just before news after holidays, slippage is likely, brokers may increase spreads just to put a category of scalpers or Arbitrage traders under check. This is very common to most firms that offer foreign exchange brokerage services for retail traders.
How firms profit from restricting Arbitrage
Brokers or firms that offers brokerage services to retail traders or instructional traders usually earn commissions or spreads. Market makers charge spreads while the ECN brokers charge commissions. As we’ve mentioned above, arbitrage is when there’s an imbalance of price of the same commodity. To make money from such a scenario, certain arrangements has to be put in place by the respective broker. These include
Retail traders’ discrimination; if a broker realizes that such a scenario is happening frequently on a particular stock, then the broker offering the platform to retail traders can limit retail traders with less capital from trading that particular stock at such a particular time. Instead they should encourage institution traders who buys in large volume to trade and therefore charge them higher volume at that particular time.
For example, a broker offers Canadian Pacific Railway (CP) stocks for buying and selling on their trading platform. The broker has access to the exchange rates from both NYSE and Chicago exchanges, currently the price per share of CP in both exchanges is USD 215.00. The broker charges a commission of USD 5 per share bought or sold. An average retail trader buys a total of not more than 100 shares while the institutional traders’ buys and sells more than 100,000.
This means that, every time there’s an active transaction, the broker makes $500 from retail trader while he makes $500,000 from the institutional traders. Assuming suddenly the price of CP at NYSE rises to $220.00, but declines to $200 at the Chicago. This is an arbitrage advantage to the broker depending on how he handles. Other than using the robot to handle such situation. The broker can temporarily disable trading for retail trading or rise the commission for retail traders but lower commissions for the institutional trader (IT). This will result into more transactions from IT therefore increase in volume of transactions and therefore more profits in terms of commission. In this case, the broker makes nothing from retail traders, but instead of getting $500,000, he’ll probably get double transactions as result of low commissions. This in turn improve their volatility.
List of Reference
AUSTRALIAN SECURITIES EXCHANGE. (2015). Starting out in shares: the ASX way. http://public.eblib.com/choice/publicfullrecord.aspx?p=4029270.
BJÖRK, T. (2009). Arbitrage theory in continuous time. Oxford, Oxford University Press.
JARECKI, N., GERE, R., SARANDON, S., ROTH, T., & MARTINEZ, C. (2015). Arbitrage. [Utrecht] : Dutch Filmworks,
NEW YORK STOCK EXCHANGE. (2018). NYSE Magazine. http://www.nyse.com/about/publication/MagazineTOC_CurrentIssue.html.
NATIONAL ASSOCIATION OF BOND LAWYERS (U.S.). (2010). Arbitrage. Hinsdale, IL, National Association of Bond Lawyers.