Arbitrage is trading that exploits the tiny differences in price between identical assets in two or more markets. The arbitrage trader buys the asset in one market and sells it in the other market at the same time in order to pocket the difference between the two prices. There are more complicated variations in this scenario, but all depend on identifying market "inefficiencies."

Arbitrageurs, as arbitrage traders are called, are usually working on behalf of large financial institutions. It usually involves trading a substantial amount of money, and the split-second opportunities it offers can be identified and acted upon only with highly sophisticated software.

What Are Some Examples of Arbitrage?
The standard definition of arbitrage involves buying and selling shares of stock, commodities, or currencies on multiple markets in order to profit from inevitable differences in their prices from minute to minute.

However, the word arbitrage is also sometimes used to describe other trading activities. Merger arbitrage, which involves buying shares in companies prior to an announced or expected merger, is one strategy that is popular among hedge fund investors.

Why Is Arbitrage Important?
In the course of making a profit, arbitrage traders enhance the efficiency of the financial markets. As they buy and sell, the price differences between identical or similar assets narrow. The lower-priced assets are bid up while the higher-priced assets are sold off. In this manner, arbitrage resolves inefficiencies in the market’s pricing and adds liquidity to the market.