What is Arbitrage? The Law of One Price

Arbitrage is the simultaneous purchase and sale of an asset in different markets to exploit tiny price differences. It ensures market efficiency.

Arbitrage is the practice of taking advantage of a price difference between two or more markets. In its purest form, 'riskless' arbitrage involve striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices. In 2023, most pure arbitrage opportunities are identified and executed by high-frequency trading (HFT) algorithms in microseconds, leaving almost no gap for manual traders.

The existence of arbitrage supports the Law of One Price, which states that identical goods should sell for the same price in different locations. If Bitcoin is trading at $30,000 on Coinbase and $30,050 on Binance, an arbitrageur will buy on Coinbase and sell on Binance. This buying pressure on the cheaper exchange and selling pressure on the more expensive one forces the prices to converge.

While pure arbitrage is theoretically risk-free, most modern quants engage in Statistical Arbitrage (StatArb). This involves using mathematical models to identify mean-reversion opportunities between correlated assets, such as pairs trading. If the historical spread between Pepsi and Coca-Cola widens beyond a 2-standard-deviation threshold, a trader might short the overperformer and go long on the underperformer, betting that the relationship will normalize.