Arbitrage is the practice of profiting from the mispricing of an asset that trades in multiple markets. For arbitrage to be possible, an asset must trade in at least two different markets. If the same asset is trading in two different markets with two different prices, there is an arbitrage opportunity. The idea is to buy the asset where it is cheaper, sell it where it is more expensive, and pocket the difference.
For example, imagine you can buy an apple at the supermarket for fifty cents and sell it to tourists on the sidewalk for one dollar. This is an arbitrage opportunity. You would buy apples at the supermarket and sell them to the tourists. For each apple, you would profit 50 cents.
Similarly, if one US dollar is worth .5000 British pounds in London, and one US dollar is worth .5001 British pounds in New York, the arbitrageur might want to purchase dollars with pounds in London and then sell the dollars for pounds in New York. Depending on the volume and the transaction costs, this could be a profitable arbitrage opportunity.
Arbitrage and Market Efficiency
Due to market efficiency, arbitrage opportunities are hard to find. When they do exist, they are typically small and fleeting. Profiting significantly from arbitrage often requires timely action and large sums of money. And because of market efficiency, the very act of engaging in arbitrage serves to eliminate the arbitrage opportunity.