How Arbitrage Stock Trading Works

Arbitrage stock trading occurs when a trader purchases a stock in one exchange and sells it in another where the price is slightly higher. For instance, if a stock trades for $20 on the NYSE and $20.05 on the LSE, a trader can buy on NYSE and sell on LSE to capture a $0.05 per share profit.

This is only feasible if trading systems are fast enough and transaction costs don’t wipe out the gain. Modern algorithmic trading platforms often eliminate arbitrage opportunities in seconds, making speed and accuracy critical.

Examples of Stock Arbitrage

Simple Stock Arbitrage Example

TD Bank is priced at $63.50 CAD on the Toronto Stock Exchange and $47 USD on the NYSE. At a 1.35 exchange rate, $47 USD = $64.39 CAD. Buying on the TSX and selling on the NYSE yields a $0.89 CAD per-share arbitrage.

However, stock arbitrage isn't always profitable once transaction fees and slippage are factored in. Profitable arbitrage must exceed all associated costs.

Complex Arbitrage Trading Strategies

Triangular Arbitrage

Involves converting one currency into another across three institutions and profiting from the exchange rate differentials. For instance:

• $2M → 1.788M EUR → 1.401M GBP → $2.006M USD
• Net profit = $6,596 without assuming market shifts.

Risk Arbitrage Trading

Occurs during M&A activity. Traders bet on price gaps between the acquirer and the target company. If the deal breaks, losses can exceed 20%, though typical gains are around 3-5%.

Index Arbitrage

Traders buy all components of an index while selling futures. Profit depends on dividends earned minus interest and futures cost. Small deviations in interest rates or dividend payouts can reverse profits.

Carry Trade

Borrow in low-interest currency and invest in high-interest currency or bonds. If forex rates move against the trade or if forward contracts nullify the gain, profits evaporate.

International Arbitrage Trading

Traders exploit price differentials between American Depository Receipts (ADRs) and Ordinary Shares (ORDs). Complexities include currency risk, market timing mismatches, and conversion costs.

Convertible Arbitrage

Uses convertible bonds (hybrid debt with embedded options). Traders hedge with short positions in common stock or call options. Complex modeling and risk management are essential, as losses can arise from volatility, interest rate changes, or credit events.

Summary: Arbitrage in Stock Market Trading

Arbitrage trading is about precision, speed, and exploiting inefficiencies in pricing. While opportunities like stock arbitrage, triangular arbitrage, and index arbitrage exist, they require advanced systems and deep market knowledge.

Done right, this trading can yield steady profits. Done poorly, it can amplify risks through leverage, timing issues, or flawed assumptions.Learn to trade smarter with PROP365. Start your trading journey today at PROP365 and put these strategies into action.