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What Is Arbitrage?

Arbitrage Examined

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[Q:] What is arbitrage? What markets do arbitrageurs usually trade on?

[A:] Terrific question! Let's start from the definition. The Economics Glossary defines arbitrage opportunity as "the opportunity to buy an asset at a low price then immediately selling it on a different market for a higher price." If I can buy an asset for $5, turn around and sell it for $20 and make $15 for my trouble, that is arbitrage. The $15 I gain represents an arbitrage profit.

Arbitrage profits can occur in a number of different ways. We'll look at a few examples:

One Type of Arbitrage - One Good, Two Markets

Suppose Walmart is selling the DVD of Shaft in Africa for $10. However, I know that on eBay the last 20 copies of Shaft in Africa on DVD have sold for between $25 and $30. Then I could go to Walmart, buy copies of the movie and turn around and sell them on eBay for a profit of $15 to $20 a DVD. It is unlikely that I will be able to make a profit in this manner for too long, as one of three things should happen:
  1. Walmart runs out of copies of Shaft in Africa on DVD
  2. Walmart raises the price on remaining copies as they've seen an increased demand for the movie
  3. The supply of Shaft in Africa DVDs skyrockets on eBay, which causes the price to fall.
This kind of arbitrage is actually quite common on eBay. Many eBay sellers will go to flea markets and yard sales looking for collectibles that the seller does not know the true value of and has priced much too low. They will buy the rare collection of Colecovision games from the yard sale for $10 then turn around and sell them on eBay for $100. There are costs to this however. First of all, you don't find rare Colecovision games just lying around, you have to spend time and energy looking for them. Secondly, you have to spend time learning what is valuable and what is not valuable so you don't find out later what you thought was worth $100 is only worth $5. Lastly, just because something has sold for $100 in the past does not mean it will sell for $100 again in the future. So given both the financial costs and the opportunity costs involved, we would expect arbitrageurs on this market to make as much money as they would doing other productive activities that require the same set of skills.

One Good, Two Markets Arbitrage in Sports Gambling

Arbitrage of the "One good, Two markets" variety is quite common in the world of sports gambling. Arbitrage on the sports market exists because different betting agencies often post different odds on the outcome of a game. Suppose the White Sox are playing the Red Sox. Bookmaker Billy is giving even money on the game, so a $100 bet placed on either team will earn you $100 if the team you picked wins. Sportsman Steve has the White Sox at +200, which means if you place a $100 bet with Steve on the White Sox to win, you will get $200 if they win, and $100 if they lose. You can guarantee yourself a profit if you make the following bets:
  1. Place a $300 bet on the Red Sox with Billy at even odds.
  2. Place a $200 bet on the White Sox with Steve at +200.
In baseball there are no ties. So either the Red Sox will win, or the White Sox will win.

Profit if the Red Sox Win

If the Red Sox win, Billy pays you $300. However since the White Sox lost, you lost your bet with Steve and must pay him $200. Your profit is $100, as that's the difference between what Billy pays you and what you must pay Steve.

Profit if the White Sox Win

Since the bet you made with Steve on the White Sox was at +200, Steve pays you $400 for your $200 bet. Since the Red Sox lost, you must pay Billy $300. Again your profit is $100, represented by the difference of what Steve pays you and what you must pay Billy.

There are a number of gamblers who try to exploit differences in odds from bookmaker to bookmaker. It's not quite as profitable as it seems, as the odds do not generally differ as much as they do in this example, plus you have to pay the bookmaker in order to place the bet as that's how they make their money.

Be Sure To Continue To Page 2 of What Is Arbitrage?

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