Definition (short)
– An arbitrageur is an investor who seeks to profit from price differences for the same asset or economically linked assets. These traders try to buy where a security is relatively cheap and sell where it is relatively expensive, or exploit value gaps created by corporate events such as mergers. Arbitrage is often described as exploiting market inefficiencies, but the trades are rarely completely “risk‑free.”
Two common types of arbitrage
– Cross‑market arbitrage: buying an asset on one
exchange and selling it on another where the price is higher. This
This requires nearly simultaneous execution and fast settlement to lock in the spread; small delays, fees or transfer costs can erase the apparent profit.
Other common forms of arbitrage
– Merger arbitrage (risk arbitrage): buying the stock of a target company after a takeover announcement and shorting the acquirer (or simply buying the target) to capture the spread between current market price and the deal consideration. Profit depends on the deal closing; failure or renegotiation is the primary risk.
– Triangular arbitrage (foreign exchange): exploiting inconsistent cross‑rates between three currencies. For example, if EUR/USD × USD/JPY ≠ EUR/JPY, converting currencies in a loop can yield a riskless profit in theory.
– Statistical arbitrage: using statistical models to trade baskets of securities whose prices are historically correlated, betting that short‑term deviations will revert to the mean. This is model‑driven and carries model and execution risk.
– Convertible arbitrage: buying convertible bonds and hedging equity exposure (often by shorting the underlying stock) to profit from mispricing between the bond and the embedded option.
– Index/ETF arbitrage: buying or selling the basket of underlying securities and taking the opposite position in an ETF to capture small NAV (net asset value)–market price discrepancies.
Checklist before attempting an arbitrage trade
– Market access: accounts on the relevant exchanges or instruments; ability to short if needed.
– Capital and margin: sufficient funds and margin capacity to carry both legs of the trade.
– Execution speed: order routing, low latency, and co‑location as needed.
– Fee estimation: commissions, bid/ask spreads, exchange fees, transfer fees, and taxes.
– Settlement mechanics: same‑day vs. T+2/T+3 rules, cross‑border settlement lags and currency conversion times.
– Counterparty risk: creditworthiness of brokers/prime brokers and clearinghouses.
– Regulatory compliance: shorting rules, trade reporting, and market‑specific restrictions.
– Risk management: stop rules, position limits, and scenario planning for deal failure or abrupt price moves.
Worked numeric example — simple cross‑market arbitrage
Assume:
– Stock XYZ trades on Exchange A at $100.00 (ask) and on Exchange B at $100.50 (bid).
– Commission per side: $0.10; per‑share fees/transaction costs (routing, exchange): $0.05 per side.
– You plan to trade 1,000 shares.
Steps and calculation:
1. Buy 1,000 shares on Exchange A at $100.00. Cost = 1,000 × $100.00 = $100,000.
2. Sell 1,000 shares on Exchange B at $100.50. Proceeds = 1,000 × $100.50 = $100,500.
3. Gross spread = $100,500 − $100,000 = $500.
4. Trading costs = (commission + fees) × 2 sides × 1,000 shares = ($0.10 + $0.05) × 2 × 1,000 = $300.
5. Net profit before financing and tax = $500 − $300 = $200.
6. Annualize or compare to capital used: if execution required borrowing shares or margin, include interest; if settlement lag creates exposure, add potential price‑move risk.
If settlement or transfer between exchanges takes time, you may need to hold positions overnight or borrow stock, which adds risk and cost. If any fee
If any fee or slippage erodes the spread, the apparent profit can vanish. Always include every cost and possible friction when you calculate net arbitrage profit: explicit commissions, exchange and routing fees, bid‑ask spread, market impact (price move caused by your order), clearing and settlement fees, borrowing fees if you short, interest on margin or cash financing, and taxes.
Quick formula checklist
– Gross spread = (Sell price − Buy price) × Quantity.
– Transaction costs = Sum of commissions + exchange fees + market‑impact estimate + bid/ask cost.
– Financing & borrow cost = (Value × annual rate × days/365).
– Net profit = Gross spread − Transaction costs − Financing & borrow cost − Taxes.
Worked example (continuing the earlier numbers)
1. Gross spread = ($100.50 − $100.00) × 1,000 = $500.
2. Trading costs already computed = $300.
3. Net before financing/tax = $200.
4. Financing cost (example): borrow cash $100,000 at 5% annual for 2 days:
Interest = 100,000 × 0.05 × (2/365) = $27.40.
5. Stock borrow fee (if you had to borrow shares) at 2% annual on $100,500 for 2 days:
Borrow fee = 100,500 × 0.02 × (2/365) = $11.01.
6. Net after financing/borrow = $200 − $27.40 − $11.01 ≈ $161.59.
Assumptions: interest and borrow rates are illustrative; settlement period = 2 days; taxes ignored. Change any assumption and recompute.
Execution checklist for a simple cross‑exchange arbitrage
1. Confirm quotes on both venues simultaneously (use timestamped data).
2. Calculate gross spread and then add: commissions, exchange fees, routing fees, and estimated market impact.
3. Check settlement timings and whether short
3. Check settlement timings and whether short selling is allowed on the instruments/venues. If you intend to short, verify the ability to borrow shares (locate process), the stock‑borrow fee, and any restrictions on holding short positions across settlement or overnight. Confirm whether one venue uses T+0, T+1, T+2, or other settlement conventions and whether cash or securities transfers will be available fast enough to net positions.
4. Confirm margin and capital availability. Make sure your account has required margin or pre‑funded cash to cover both legs plus worst‑case exposure if one leg fails. Calculate maximum intraday and overnight capital tie‑up; pre‑allocate that capital before sending orders.
5. Choose order types and routing. Decide which order types to use (market, limit, immediate‑or‑cancel, fill‑or‑kill) for each leg to balance execution probability against price. Pre‑select smart‑routing or direct routes; know routing fees and potential rebates.
6. Size and market impact. Compute how many shares/contracts you can trade without moving the market beyond the arbitrage spread. Estimate market impact (price slippage) per lot; include a buffer. Example: if available depth at best bid/ask is only 1,000 shares and you need 10,000, you must either slice the order (raising execution risk) or reduce size.
7. Latency and synchronization risk. Ensure your data feed timestamps are synchronized and that your execution system can place the two legs near‑simultaneously. For small spreads, milliseconds matter; for larger spreads, seconds may suffice. Have a plan for partial fills (e.g., cancel remaining leg, reprice, or hedge).
8. Pre‑trade risk limits and kill switches. Set numeric thresholds for: maximum notional per trade, maximum number of open arbitrage legs, maximum time to execution before cancel, and maximum tolerated loss per trade. Implement automated kill switches to cancel outstanding orders if thresholds are breached.
9. Post‑trade reconciliation and settlement monitoring. Immediately reconcile fills on both venues. Track fails-to-deliver, borrow status for shorts, settlement instructions, and cash movements until positions are fully settled. Log timestamps and order IDs for audit trails.
10. Compliance and reporting checks. Verify that your strategy complies with exchange rules, short‑sale regulations (e.g., locate requirement), market‑abuse rules, and broker terms. For cross‑jurisdiction trades, check currency conversion rules and capital controls.
Quick break‑even formula (per trade)
Required gross spread per unit >= (total round‑trip costs) / quantity
Where total round‑trip costs = commissions + exchange/routing fees + estimated market impact + financing + borrow fees + taxes/other fees.
Worked numeric example
– Planned size: 10,000 shares.
– Expected price difference (gross spread): $0.05 per share → gross profit = 10,000 × $0.05 = $500.
– Costs:
– Commissions: $0.01 per share roundtrip → 10,000 × $0.01 = $100.
– Exchange/routing fees: $0.002 per share roundtrip → $20.
– Estimated market impact/slippage: $80.
– Financing/borrow (intraday small): $10.
– Contingency buffer (partial fills, misc): $50.
– Total costs = $100 + $20 + $80 + $10 + $50 = $260.
– Net profit = $500 − $260 = $240. If any cost estimate increases or execution degrades, re‑compute before proceeding.
Common pitfalls and operational risks
– Stale or delayed quotes: apparent arbitrage disappears when quotes refresh.
– Execution (leg) risk: one side fills and the other does not.
– Short‑borrow failure: inability to borrow shares leads to forced buy‑in at adverse prices.
– Hidden fees: routing surcharges, regulatory fees, or clearing charges.
– Settlement mismatch across venues/currencies causing overnight exposure.
– Regulatory scrutiny: repeated latency or cross‑market behavior can attract surveillance.
Pre‑trade quick checklist (yes/no)
– Are both quotes timestamped
– Are both quotes timestamped and from a reliable feed? (yes/no)
– Do the timestamps indicate contemporaneousness within your latency tolerance? (yes/no)
– Are the displayed sizes sufficient on both legs to cover the intended quantity? (yes/no)
– Is the destination venue and order type (limit/market/peg) selected for each leg? (yes/no)
– Have you calculated all explicit costs (commissions, exchange fees, clearing fees)? (yes/no)
– Have you estimated implicit costs (expected slippage, market impact)? (yes/no)
– Is there a confirmed borrow available for any short leg, and is the borrow rate acceptable? (yes/no)
– Are margin and capital requirements met for the position through settlement? (yes/no)
– Do settlement times align (T+ settlement mismatch or currency-settlement mismatch)? (yes/no)
– Have pre-trade risk limits (max notional, max size per leg, maximum allowed latency) been checked? (yes/no)
– Is an abort/kill criterion defined if one leg fails to fill within X milliseconds/seconds? (yes/no)
– Has compliance/recording (trade ticket, order IDs, audit trail) been enabled? (yes/no)
If any answer is “no,” stop and resolve the item before sending orders.
Execution checklist (step-by-step)
1. Lock in sizes: set order quantities to the lesser of displayed sizes on each venue minus a safety buffer.
2. Set limit prices: place passive limits that capture the arbitrage spread plus an acceptable buffer for movement.
3. Stagger or pair orders: submit both legs simultaneously where possible; if sequential, submit the leg most likely to move adversely first only if you can hedge the risk immediately.
4. Monitor fills: watch for partial fills; avoid assuming remaining quantity will fill at quoted price.
5. Abort rules: cancel outstanding leg(s) if the counter-leg fails to fill within your pre-set timeout.
6. Post-fill hedge: if fills are asymmetric, enter hedging trades to neutralize directional exposure immediately.
7. Record everything: timestamps, order IDs, venue responses, and market snapshots before and after execution.
Numeric working example (how to re‑compute quickly)
Formulas:
– Gross proceeds (if short/sell on A, buy on B): Gross = (SellPriceA − BuyPriceB) × Quantity
– TotalCosts = Commissions + ExchangeFees + BorrowCost + EstimatedSlippage + Buffer
– NetProfit = Gross − TotalCosts
Example:
– SellPriceA = $25.30; BuyPriceB = $25.00; Quantity = 2,000 shares.
– Gross = (25.30 − 25.00) × 2,000 = $600.
– Suppose Commissions = $40, ExchangeFees = $30, BorrowCost (overnight) estimate = $80, EstimatedSlippage = $100, Buffer = $50.
– TotalCosts = 40 + 30 + 80 + 100 + 50 = $300.
– NetProfit = 600 − 300 = $300.
If borrow cost jumps to $200 intra‑day, recompute:
– New TotalCosts = 40 + 30 + 200 + 100 + 50 = $420 → NetProfit = 600 − 420 = $180.
Decision rule: proceed only if NetProfit exceeds your minimum required threshold and risk limits.
Common abort/mitigation triggers
– One leg filled and the other shows no available size for your remainder.
– Quote midpoints move against you by more than your slippage tolerance.
– Borrow for a short leg is recalled or rate spikes beyond preset limit.
– Regulatory or venue outage detected on a required execution path.
Post‑trade reconciliation and controls
– Immediately capture end‑of‑trade market snapshots for both venues (bid/ask, sizes).
– Reconcile executed fills vs. order confirmations (price, size, timestamp).
– Record borrow details: lender, rate, term, and any recall notices.
– Mark-to-market and check P&L using end‑of‑day prices; compare realized vs. expected.
– Log any exceptions and perform root‑cause analysis for failed legs or unexpected costs.
– Archive audit trail for required retention period per local regulation.
Operational best practices
– Use low‑latency, audited market feeds and synchronized clocks (e.g., NTP or GPS) for reliable timestamps.
– Maintain a small conservative buffer in profitability calculations to cover sudden spikes in fees or slippage.
– Test strategies in simulation with historical order book playback before going live.
– Implement kill switches that can liquidate or cancel positions on systemic failures.
– Keep a compliance contact list and pre‑approved escalation procedures for regulatory inquiries.
Checklist for ongoing monitoring (daily/weekly)
– Verify short‑borrow inventory and rates.
– Review failed or partial fills and update execution algorithms accordingly.
– Re-assess fee schedules and exchange rebates that affect profitability.
– Ensure software and connectivity patches are current, and