What are the Different Types of Arbitrage Opportunities?
Risk free arbitrage opportunities in financial markets are the domain of professional trading organizations. Computer algorithms are constantly searching the markets for price discrepancies in the same or similar markets. The simultaneous purchase and sale of a financial asset to obtain a small but risk free profit might exist for seconds or possibly minutes. Market makers, specialists, and hedge funds equipped with the means to discover these opportunities and the ability to capitalize on them leave few, if any, arbitrage opportunities for the average investor.
Arbitrage opportunities in the futures market occur when the spot price of the underlying asset and the futures price does not represent fair value. This temporary situation can happen due to an unusual event or news release. Arbitrageurs typically step in immediately to profit from the discrepancy and return the market to fair value. These traders play an important role in maintaining stability and equilibrium in the markets.
True arbitrage trades are executed simultaneously. The similar assets are bought and sold at the same time, locking in a risk free profit immediately. These free money trades are found in the derivatives market due to inefficient methods used in derivatives pricing. Arbitrage opportunities are very hard to find and don't last long. Free money attracts the best and biggest traders who immediately capitalize on fleeting opportunities.
The options markets frequently present arbitrage opportunities due to put and call values falling out of alignment with asset values. The conversion trade is a synthetic option position traded against the actual cash position in the underlying asset. A small profit can be made when the price of the option and the price of the underlying asset move back into alignment. This kind of trading is typically not suitable for the average investor since it requires a great deal of time and expertise.
Since market inefficiencies are quickly exploited by trading professionals, arbitrage opportunities could be viewed as finding trades with very low risk exposure. Although this is not true arbitrage, it may be as close as the average investor can get. Low risk trades can be developed by the investor with a great deal of knowledge about the derivatives market. This form of arbitrage involves risk, which is the nature of trading.
Occasional opportunities exist in the futures spread market. Trading different futures contracts for price corrections can result in small profits with limited risk exposure. Pairs trading involves two very similar securities that generally move in tandem with the market. A price divergence between the pair may provide a chance to profit from the eventual return to correlation. Online services provide lists of pairs trading opportunities.
Limited risk trades can be developed using various option and spot combination trades. Delta neutral and market neutral positions can offer limited risk with unlimited profit potential if set up properly. The investor should have a thorough knowledge of options risk and pricing methods before attempting these trades.
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