Example
You splurged & bought yourself a $400 Apple Watch- something you've always wanted.
While waiting for it to arrive, you notice an ad for an Apple Watch on sale for $300 — a $100 difference!
You buy that $300 watch too, then pop over to eBay and list the “old” one for $400.
Assuming this all goes to plan, you’ll pocket $100 from selling the watch on one marketplace for a higher price and buying it for a lower price on another, which now makes you an arbitrageur.
Concept
You own the item and want to continue owning it. You can now own it for less by selling it for higher and re-buying it for lower.
You don’t own the item and do not want to own it. You can pocket some extra cash by buying it for lower and then selling it for higher.
Within financial markets, arbitrage is possible because price differences exist all the time.
Arbitrageurs sell and buy the same investment, in order to pocket the “spread” — the difference between two prices.
Because this brings public attention to the difference, the spread shortens and prices again are aligned, a process that happens very quickly in today’s online marketplaces.
Arbitrage comes with risk — a concept known as “limits of arbitrage,” and only individuals/institutions with capacity to quickly make large purchases and sales can participate in day to day arbitrage opportunities.
Takeaway
As a reward for their willingness to take on the risks, successful arbitrageurs make a profit.
By doing this, arbitrageurs bring attention to mispricings which are then quickly eliminated.
Ideally, this helps ensure investors buy at stable prices, which helps maximize their long-term rate of return.
Learn More
Check out this article from Alpha Architect on the “Limits of Arbitrage”.