Arbitrage is the practice of taking advantage of a price difference between two or more markets.
A simple example: you may find a luxury product costing $50 at a thrift store or an auction, but luxury-conscious customers may pay $500 for that same luxury product at a boutique or online. That $450 is the arbitrage opportunity.
Historically, we have seen arbitrage in all kinds of markets, especially financial ones:
- Gold prices in one location versus another.
- Currencies: you can swap $1 for €1 in the US, but swap €1 for $1.10 in Europe. If you can make these swaps quickly enough, you can benefit from the additional $0.10 you get in one trade over the other.
- Commodities: agricultural products, especially, but also metals or energy products vary in price based on location, timing and political factors (among others).
- Stock investing: we estimate a business to be worth $50 million, but it’s selling for $25 million, giving us $25 million in “free” value, if purchased. It depends, of course, on your correct estimation of the business, which comes with skill, knowledge and experience. It’s this belief in arbitrage (along with human psychology) that creates the volatility in the stock market, and thus the arbitrage opportunities.
Another simple example: The only gas station in a 50-mile radius can buy gasoline and sell it at the desired profit it wants (temporarily) without interference.
In most markets, nearly all arbitrage situations eventually disappear as they are discovered and exploited – competition gets rid of the opportunities.
Markets create arbitrage, but it’s your skill and knowledge that allows you to spot these opportunities. That’s why you would do well to continuously operate within and increase your circle of competence.
“True” arbitrage exists only when there is no market risk. Unfortunately, most arbitrage opportunities involve some type of risk:
- Execution risk: part of the transaction fails – you purchase 3 apples, but are only able to sell 2 or only able to sell 2 at the price you wanted.
- Counterparty risk: the party you’re selling to fails to pay.
- Liquidy risk: if you have an option to purchase something at a certain price or discount (but haven’t done so yet), are required to pay, but don’t have the cash to do it.
There are various types of arbitrage:
- Geographical or spatial arbitrage: price differences between geographically separate markets.
- Labour arbitrage: moving your business assets to countries with the lowest labour costs and paying less money for the same work. A form of geographical arbitrage.
- Grey market: buy items through marketing channels that sell them without the permission of the product trademark owner and sells them in the legitimate market.
- Merger or risk arbitrage: buying/holding the stock of a company that is the target of a takeover while shorting the stock of the acquiring company.
- Retail arbitrage: buying an item from one market (thrift shop, eBay) and reselling it on another market at a higher price (boutique, Amazon).
- Statistical arbitrage: an imbalance in expected nominal values and using mean reversion to your advantage.
- Example: a casino has a statistical arbitrage in every game of chance that it offers – if enough games are played, the house always wins (house advantage).
- Time arbitrage: taking advantage of short-term price changes that do not correspond with the longer term value.
- Example: buying a stock of a great business of which the price dipped because of temporary fear, dislike or uncertainty in the markets.
Arbitrage can be found not only in financial markets or business, but in every area of life and you would do well to look for and use it as often as possible. Increasing your circle of competence and knowledge – your own or borrowed from trusted relationships – help you identify more arbitrage opportunities; using probabilistic thinking allows you to compare them and pick the opportunity with the best asymmetric returns.
Not looking for arbitrage opportunities makes life more difficult and success more elusive than need be. Do yourself a favour: start searching for these opportunities in every area of your life.
How to use Arbitrage
In investing, buying a company/stock/commodity for $100 when it’s worth $200. The accuracy of your valuation depends on your skill and knowledge: how well do you understand what you’re trying to purchase.
Decrease your risk by increasing your margin of safety: the difference between what you pay and what you get in value.
In business, find products that are sold for $10 in one market and which you can sell for $50, $100 or even more in another market.
A good example is a garage sale: you find a pile of Pokemon cards that you can buy for $5. In that pile you find a well-preserved card that is in high demand that you can sell for $1,000+ via eBay.
Another example: flipping a house. You buy it for $100,000, add $30,000 in renovation costs and sell it for $200,000.
In both examples you run execution risk: since time elapses between the purchase and the sale, market conditions may have changed.
In marketing, attention arbitrage: for the same amount of money or time, you can get more attention on one medium than on another.
Example: $10 worth of Facebook ads may reach 1,000 people, while on LinkedIn it only reaches 500 and via radio or newspaper it only reaches 100 people.
Attention is not the end-all-be-all – conversion rates and quality of leads/clients matter too – but it’s a good starting point to determine where to spend your efforts and marketing dollars to get the biggest bang for your buck.
In life, if your job allows it, you can live downtown in a major city like New York or Tokyo with monthly expenses of $3,000+, or move to a cheaper city, state or country and only spend $500 monthly.
This reduced cost in living, while maintaining your income, allows you to spend, save or invest more of your money. Over time, this geographic arbitrage can compound your wealth greatly and give you financial freedom.
Moving to a cheaper location brings financial benefits, but don’t forget to consider other factors – e.g. quality-of-life, relationships – when considering this option.