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I have heard that the arbitrage strategy follows the principle of "short in expensive, and long in cheap" (Or, maybe, it was "short in cheap, and long in expensive."). I wonder how to explain this arbitrage principle?

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Isn't this just a fancy way of saying "buy low and sell high"? –  Nate Eldredge Mar 27 at 14:26

2 Answers 2

Arbitrage is basically taking advantage of a difference in price. Generally extending to "in different places for the same thing".

A monetary version would be interlisted stocks, that is stocks in companies that are on both the NYSE/Nasdaq and Toronto stock exchanges. If somebody comes along and buys a large number of shares in Toronto, that will tend to make the price go up - standard supply and demand.

But if someone else can buy shares instead in NY, and then sell them in Toronto where the first person is buying up shares, where the price is higher, they the the arbitrageur (second person) can make pretty easy money.

By its very nature, this tends to bring the prices back in line, as NY will then go up and Toronto will then go down (ignoring FX rates and the like for ease of explanation).

The same can work for physical goods, although it does tend to get more complex with taxes, duties, and the like.

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Thanks! So is taking advantage of arbitrage "short in expensive, and long in cheap" or "short in cheap, and long in expensive"? –  Tim Nov 5 '11 at 1:22
One always want to go long in that which is cheap, and short that which is expensive. –  JoeTaxpayer Nov 5 '11 at 2:14

Well, arbitrage is a simple mean reversion strategy which states that any two similar commodity with some price difference (usually not much) will converge. So either you can bet on difference in prices in different exchanges or also you can bet on difference in futures value. For example if current price of stock is 14$ and if futures price is 10$. Then you can buy one futures contract and short one stock at the market price. This would lock in a profit of 4$ per share.

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