Arbitrage stock trading is when an investor buys or sells stock while simultaneously buying or selling an off-setting stock-index future or option.
Clear as mud? Hang in there; it's easy once you understand the basic idea.
The strategy behind arbitrage is simple enough -- profit from the difference in price between the buy and sell. For example, let's assume you find stock ABC that trades on both the NYSE and NASDAQ. You see it is trading for $10 on NASDAQ and $10.50 on NYSE so you buy 1,000 shares from the NASDAQ and simultaneously sell 1,000 shares on NYSE. You profit by taking the .50 difference on the 1,000 shares for a quick $500 profit in a matter of minutes ... if everything goes as planned.
It sounds great and sometimes it actually works. In fact, traders do this repeatedly throughout the day with vast sums of money (much larger than the example above) but there is inherent risk to this strategy.
For example:
- The buy order goes through, but the sell order wasn't executed. Now, you suddenly own a lot of shares that you may or may not really want to be holding.
- The sell order is executed, but the buy order wasn't. Ouch. At the end of the day you might be forced to buy at a higher price in order to satisfy the position ... a potentially costly mistake.
- Partial orders were executed. Similar to both or either of the above but to a lesser extent.