- Smart Investing
Arbitrage – A REAL Get Rich Quick Scheme
You don’t have to go far to see an exciting headline of someone who has scored big by investing.
How This Man Made $2.8 Million Trading Stocks Part-Time From Home
I won’t put any other links here because I really wouldn’t recommend reading them but they are all over the Internet – people with “hot” stock tips, people with strategies for picking stocks based on technical indicators, people who are speculating in currency, real or electronic.
Heck, we’ve even done it by talking about a friend who made a million by investing in Bitcoin.
But in our defense, while it was fun to talk about it, we clearly state that he was just lucky and advise against this type of risky strategy unless you are working with a very small portion of your portfolio (<10%). Essentially, all of the get rich quick stories you will read on the internet will be about people who were lucky. You’ve read about people striking it rich in Vegas too – right? Same thing.
You are probably thinking that there MUST be some people who have figured out ways to beat the system. And you’d be right. And you’ll find many of those millionaires and billionaires in Hedge Funds who use sophisticated analytical techniques, data scientists and computing power to exploit anomalies in the market. A common technique has been to capitalize on what’s called “arbitrage opportunities”. Arbitrage is defined as follows:
The simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset.
Or in simple language, you find an asset (could be a stock or anything else) that you can buy for a low price and sell for a high price. Sounds like normal trading but the key is that it happens instantaneously or near instantaneously so there is no risk – you know for certain you are going to make money. To give an everyday example and one that happened to me once a very long time ago, let’s say you travel to Sudan and notice at a currency exchange that they are selling Sudanese Pounds at 52 £/$ (1 US Dollar will get you 55 Sudanese Pounds) and buying Sudanese Pounds at 55 £/$ (55 Sudanese Pounds gets you one US Dollar - the difference between the buy and sell is called “the spread” and represents the profit for the currency exchange). For whatever reason (perhaps a mistake or a system problem), the currency exchange right down the road is selling Sudanese Pounds at 56 £/$ and buying at 59 £/$.
You have $200 in your pocket so you run to the second place and buy £11,200 (56X200) and then run really fast back to the first place and sell your £11,200 for $203.64 (11,200/55) for a $3.64 profit. Theoretically you can run back and forth between the two shops, slowly growing your profit. Or, even more theoretically, you could take in $20,000 into the transaction and make $363.63, and so on (it’s only in theory as there are likely limits at each exchange or they might call to verify the exchange for such a big amount).
This isn’t arbitrage strictly speaking because the transactions were not instantaneous. In your sprint back to the first currency shop, they might have received correct information and changed their rates. Or you might fall and sprain your ankle, never getting back to the first exchange. But you get the idea.
People often misuse the term arbitrage – it is supposed to be instantaneous and therefore risk-free. For example, house flippers often use the term arbitrage to describe an opportunity to buy a house cheap, fix it up and sell it quickly. While this might be a good investment opportunity it is certainly not arbitrage because lots can go wrong between the buying moment and the selling moment (you find termites, economy tanks, meth lab discovered next door, etc).
The most famous real-life arbitrage was carried out by Spread Networks who spent billions of dollars connecting the Chicago Mercantile Exchange with the New York Stock exchange via fiber optic cable so they could take advantage of arbitrage opportunities that would only persist for milliseconds. If there was a small difference in prices between the two exchanges that lasted less than a second, they could jump on it and make some profit – repeat over and over. Given, they spent billions on the fiber, you can imagine how much they made in profits.
While most arbitrage opportunities these days are discovered by sophisticated computer algorithms and artificial intelligence, you never know, you might find one someday – keep your eyes open and you can legitimately get rich quick without being lucky. Otherwise, follow our advice and create a well-diversified portfolio of quality assets – you won’t get rich quick but you will get rich slowly.