Arbitrage basics
About this video
Arbitrage means taking advantage of price differences on essentially the same thing to make a risk-free profit. Using apples that sell for $1 in one market and $1.50 in another, the video shows buying cheap and selling dear, and explains how doing this pushes the two prices together until the profit disappears.
You'll be able to
- define arbitrage in my own words.
- calculate the profit from an arbitrage trade.
- explain how arbitrage changes supply, demand and prices in the two markets.
Key words
- Arbitrage
- Using a price difference on essentially the same thing to make a risk-free profit.
- Risk-free profit
- A gain that is locked in no matter what happens next.
- Supply
- How much of something is being offered for sale in a market.
- Demand
- How much of something buyers want to buy in a market.
Transcript
The word arbitrage sounds very fancy, but it's actually a very simple idea. It's really just taking advantage of differences in price on essentially the same thing to make risk-free profit. So let's just think about a little bit. Let's say in one part of town there's some type of a market.
Let's say it's a market for apples. And let's say in that market, apples sell for-- just make up some price. Let's say that apple's in that market, sell for $1 an apple, $1 per apple. And let's say in another part of town, you have another market. Another market's literally a fruit market.
And in that other part of town, apples sell for $1.50 an apple. And we're going to assume that these apples are completely identical apples. How could you take advantage in this price difference on these identical things to make a risk-free profit? Well ideally, you would want to sell apples in the more expensive market where you could get $1.50 per apple.
And you would want to buy apples in the less expensive market where you can get them for $1 per apple. And that's exactly what you would do. You would go do this market over here, you would buy apples. Let's say you buy 10 apples for $10. And then you would go maybe ride your bicycle a couple of blocks to that other market over there.
And you would sell your 10 apples. So this is buy 10 apples for $10. And then you would sell those 10 apples for $15. And so you would make an immediate risk-free profit of $5. You're buying for 10, selling at 5. And you could just keep doing that over and over again.
And on every trip as many apples as your bicycle could carry you'll just continue to make money. And so this is what arbitrage is. And just imagine a side effect. If someone did this enough, then what would do is it would increase the supply of apples here. So supply would increase in this market.
And on this market, the demand would increase because there's someone who just keeps buying from this market and selling into that market. So what's eventually going to happen when demand increases, the price will go up in this market. And when the supply increases in this market, the price will go down.
So in theory, the more you do this, the more that you're going to make these prices come closer to each other. And eventually, you won't be able to make any profit at all. But while there's this discrepancy, you have an opportunity for arbitrage.
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