How to Effect Arbitrage Transactions
‘Buy cheaper, sell higher’- if you have puzzled out how ordinary stock speculation works (in both short- and long-term format), you are familiar with the essence of so-called arbitrage transactions. This is the basics of classical trading on stock markets.
The simplest example of an arbitration transaction is a temporal arbitration. You buy an asset cheaply (for example, a Walt Disney Company share for $100), you hold up until the improvement in exchange, when it happens, you sell. For example, when the Walt Disney Company share grows to $115. For such transactions, the broker takes a low commission (usually it is a percentage of the transaction charge), so the temporal arbitration is popular with traders.
Things get a bit more complicated with cross-border arbitration.
Cross-border arbitrage transactions on the securities market
The simplest scheme of a cross-board arbitrage transaction is:
- You buy ‘cheap’ securities;
- Convert them into ‘expensive’ ones on another stock exchange;
- Sell and calculate profits.
Walt Disney Company shares are simultaneously listed on 3 exchanges: on the New York Stock Exchange in USD, on the Frankfurt Stock Exchange in EUR and on the Swiss Exchange in CHF. Each moment there is a certain price discrepancy.
Given that the relevant currency pairs are always traded on FOREX currency market, we can easily calculate which shares are cheaper at the moment and vice versa.
How to make money on this?
You can purchase ‘cheap’ stocks, and sell expensive ones in short, which means that you open a short position, borrowing shares for sale from a broker. And wait until prices tally at the same rates: this method is also called ‘catch the discrepancy.’ But not all the brokers have accesses to all the trading platforms and not all the brokers possess the ability to lend shares.
And you can buy ‘cheap’ shares and transfer them to the exchange, where they are traded at their most expensive (or convert, if we are talking about ADR / GDR, but this method has its drwbacks).
The first and main difficulty is in the conversion process itself. It can be simplified by brokers who deal with arbitrage transactions on stock exchanges in the USA, Europe and other countries. For these services they charge an additional commission, which is often fixed.
Thus, converting or just transferring shares from one depository to another can be over € 20-30.
An arbitrage transaction is only worth trying if the potential profit covers all the expanses on purchasing and selling or converting securities.
Speed is an even more important factor. Arbitrage transactions are carried out and completed quickly, within a few minutes, or maximum in a matter of hours, which means that you must have at your disposal all instruments for trading.
The difference in the rate of exchange of currencies or commissions, the slightest delay on the part of the broker can even out your profit. Therefore, it is better to deal with arbitrage transactions only if you are seriously involved in trading and have done this for quite some time by the standard scheme of temporal arbitration.
Other examples of arbitration transactions
The most profitable arbitrage transactions cannot be conducted on the exchange floor; those require expanding beyond exchanges, and the stock market itself. You can trade on commodity and currency markets, combine and alternate different assets, even crypto-currency, purchase goods in one country and sell to another.
Arbitrage transactions level quotes for the same assets on various exchange floors and adjust their market rate.
Try for arbitrage transactions only if you intend to engage in serious trading, buy and sell securities on daily basis. If you only see shares as an investment tool and do not wish to take risks, arbitrage will only bring you losses.