Arbitrage is buying in one market and simultaneously selling in another market profiting from a temporary difference. This is risk-less profit for investor or trader.
For example, a buyer buys oranges from Florida at $1 a pound and sells immediately to someone in New York for $1.10 per pound. The buyer in New York is paying for the storage and transportation cost. In this process, the buyer in Florida made 10 cents per pound. As long as someone is willing to buy from the buyer at the higher price he can repeat the process all day long and thus make riskless money in this process.
The same concept can be applied in stock and options markets through basic call and put options.
For example, stock AXY is trading at $50.00 bid and $50.10 ask and AXY June 40 call options is offered at a discount price of $9.80. The call is supposed to be trading at least at $10.00 (Stock Price – Strike Price). Since calls are being offered at $9.80 that is 20 cents discount. When arbitrageur spots this situation he moves in at lightning speed (before anyone knows what happened) and take advantage of this situation by adopting the following strategy:
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He will buy June 40 calls for $9.80 each in AXY stock
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He will short the AXY stock at $50.00 per share
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He will then turn around and exercise the call to buy AXY at $40.00 per share
Let’s say he is dealing with 1000 shares and 10 contracts. Each contract controls 100 shares most of the time.
Since our arbitrageur bought June 40 calls, therefore, he has the right to buy the stock at $40.00 per share.
Here is the Math:
Arbitrageur bought 1000 shares at $40.00
His investment in the stock = $40 *1000 = $40,000
Arbitrageur bought 10 calls at $9.80 His investment in calls = $9.80 * 10 = $9,800
His total proceed going out = $40000 +9800 = $49,800
He receives $50,000 by shorting 1000 shares
His net profit = $50000 – $49800 = $200
1000 shares and 10 contracts were taken as example. Arbitrageur has deep pockets and can handle higher quantities.
For example, if he is dealing with 1,000,000 shares and 1000 contracts, his profit in the above example will be $200 * 100 = $20,000.
If on average he finds 2 such opportunities per day his profit is approximate $40,000 per day. Yearly profit comes to 10 million dollars.