What is arbitrage trading

What is arbitrage?

definition

Anyone who engages in arbitrage tries to make a profit by using the price differences of a good in different marketplaces. One possibility for arbitrage exists if the price differences between the sub-markets exceed the transaction and transformation costs incurred and are therefore worthwhile. The markets can be separated from one another in terms of time, space or subject. Pure arbitrage transactions are risk-free for the arbitrageur, since they only take place under perfect information conditions.

Requirements for an arbitrage business

homogeneity

In order to enable arbitrage between two markets, the traded good must first meet two criteria: It must be largely homogeneous and tradable on both markets. Suitable goods are, for example, raw materials such as wheat or precious metals - but also electricity. By buying the good on one market and selling the good on the other market, the arbitrage business is profitable.

Other conditions relate to the sub-markets involved in the arbitrage: In order to make the business possible, the markets must be linked in terms of time, space or material. Except for the characteristic that defines the submarket - in arbitrage this is the higher price for the traded good, the markets must also be homogeneous, i.e. enable trading under the same conditions.

Market transparency

Another prerequisite for the creation of an arbitrage business is a minimum level of market transparency for the market players. Because an arbitrage business is only possible if they can assess the price differences in the various markets. In OTC trading, however, the transparency of the market is generally limited by the bilateral business deals. Here, however, at least part of the market can be viewed through brokers and trading platforms, so that arbitrage is also possible here.

Ideal conditions

In order to make arbitrage easier or even possible in the first place, barriers to entry or exit must be removed in many markets. These mostly arise from regulatory or legal frameworks that restrict the ideal model of the completely free movement of goods - of course also to protect the market from itself.

Opportunities for arbitrage on the German electricity market

There are no perfect framework conditions in the German electricity market, but arbitrage transactions are in principle possible. The most common form of arbitrage is the so-called quantitative arbitrage between different product types, which, due to the full transparency, brings immediate profits without risk. As a rule, however, the time windows with the profitable price differences are very short and the markets even out very quickly, since every market participant wants to use his chance of an arbitrage profit.

Example of quantitative arbitrage in the intraday market

On the electricity market it can happen that the average price of the four quarters of an hour of a megawatt hour differs from the price of the entire megawatt hour. If you buy the quarter hours individually and sell the hourly product on another market, you can make a risk-free profit - different quantities of a homogeneous good are traded at different prices.

In this example, the hourly product costs 58 euros, but the average price of the quarter hours from the same period is only 50 euros. By buying the individual quarter hours at an average price of 50 euros and selling them as a complete MWh at 58 euros, an arbitrage profit of 8 euros can be achieved.

Example of spatial arbitrage on the German electricity market

Another possibility for arbitrage is trading over a spatial distance, for example by buying cheaper abroad and selling more expensive domestically. If an electricity trader buys cheap electricity on the French electricity exchange and sells it in Germany at a better price, he has made a spatial arbitrage deal - at least in theory.

In practice, cross-border electricity trading in Europe is limited by the scarce capacities of the cross-border connection points between the national transmission networks - not enough electricity can be transported across the national network and market borders to guarantee complete freedom of market and transfer.

The temporal arbitrage on the electricity market and its limitations

Temporal arbitrage is most profitable when the price of the good fluctuates widely over a period of time. The profit opportunities arise from a different evaluation of the delivery times of the good or if the good can be purchased and sold at different times with a price difference.

Due to its time-dependent price volatility, the electricity market is actually predestined for temporal arbitrage - however, electricity can only be stored to a very limited extent, and prices on the electricity market are difficult to predict. The temporal arbitrage on the electricity market is therefore not completely risk-free and would therefore not actually be arbitrage by definition - in the energy industry, however, this is not seen as narrowly, the term "arbitrage" is also used here for time-dependent "quasi-arbitrage".

Requirements for a temporal arbitrage on the electricity market

In order to be able to carry out a profitable arbitrage on the electricity market, all costs incurred, such as transaction costs and transformation costs, must be known - in addition, a price difference is of course required.

This can also be represented in a formula:
Price submarket A < preis="" teilmarkt="" b="" +="" transaktionskosten="" +="">

If the price on sub-market A is lower than the price on sub-market B, including transaction and transformation costs, an arbitrage takes place from sub-market A to sub-market B - the electricity from sub-market A can be sold profitably on sub-market B.

Conclusion: arbitrage on the electricity market

Arbitrage on the electricity market is, like on all other markets, a speculation-free and risk-free way of making a profit - the profit is therefore also referred to as “free lunch” in the stock market jargon. Due to these circumstances, it is an option that traders like to use in every market environment - provided that the framework conditions are right with regard to the free transfer of goods and market transparency: one obstacle to arbitrage in intra-European and international electricity trading is, for example, the weakly dimensioned cross-border connection points.

Economists tend to view arbitrage as useful, as it is what is widely believed in economics to increase market efficiency. At the same time, it promotes competition, since the arbitrageur unintentionally provides the market with the knowledge that makes arbitrage possible in the first place. In the electricity market, promising conditions for successful arbitrage can be recognized very quickly - therefore the period for a profitable business is often very short-lived. Due to the rapid trade movements, imbalances between different electricity markets are quickly balanced out again, which in turn ensures stability in the market structure.

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