Arbitrage is a weird word. It sounds French. When I hear it my breathing picks up, my senses tingle, and I start grabbing for any cash I have on hand. When “arbitrage” happens it is high alert, stage 5, class 1, Man on the Move gonna get on the move time. So what is it and why all the fuss?
Merriam-Webster defines arbitrage this way – “the nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies“.
What’s so special about arbitrage? The absence of risk and the guaranteed & immediate profit, but when it presents itself, you will have to act fast as other will see it too. Price discrepancies, you may ask? These are rare instances where the normal efficiency of the market cracks, offering the arbitrageur a felling chance at risk-free profit. If you are brave, ready, researched, and lucky enough to be in the right place at the right time, then arbitrage time is profit time.
In the stock and bond markets you’ll see arbitrageurs working interest rate arbitrage on bonds, risk/merger arbitrage on stocks, and statistical arbitrage in the options and derivatives markets. That’s all well and good, but these are pretty complex and time consuming strategies not really suited for the everyday investor – we’re talking real life here and I’ll present you with 3 examples of everyday arbitrage in hopes they spark some ideas and alert your senses to find your own opportunities in everyday transactions.
Scenario #1 – Pricing Failure Arbitrage:
Here the seller is unaware of the true value of his product in a market where there are active and willing buyers setting the market via their “bid” prices. In this scenario you can buy from the seller whose “ask” price is too low and almost simultaneously sell high at the market “bid” price. The amount of the pricing error you capture is your return on investment (ROI). Ideally this is done with little to no risk.
In action > Say it’s 2009 and “We Buy Gold” stores are everywhere as gold prices hit record highs. It’s also crisis mode in the economy with many businesses failing and a time when cash is king. A store in the mall that sells a lot of cheap & gaudy 10-karat costume jewelry is going out of business, selling everything at 60% off. Lo and behold, just down the walkway is a store with a big sign out front offering top dollar for your gold. Me? I might buy a necklace for the closeout price of $64 (that seems very cheap to me) and see what Mr. Gold Man a few steps away will give me for my new 10-karat gold treasure. Oh, $86? I’ll be right back sir… I’d then gather enough capital to clean out the costume jewelry closeout sale and arbitrage my way down the hall for an immediate and risk-free 25% ROI. Where did you get all these necklaces? Mr. Gold Man may ask. About 25 yards down the hall from your front door, sir. Arbitrage sometimes hides in plan sight. Act quickly because if Mr. Gold Man sees this going out of business sale he will pounce.
Scenario #2 – Third Party Arbitrage:
Here we get something for nothing by way of a 3rd party. A way to game the system? It is possible from time to time, especially when you can buy cash money and no markup and be rewarded for your efforts…
In action > Say the US Mint is trying to get their new $1 coins with historical presidents into circulation by offering the $1 coins @ $1.00 with free shipping. While I abhor credit cards I do enjoy vacationing on the cheap so I might get myself a Southwest VISA card and order $5,000 worth of coins. When the UPS man arrives I’ll have him drop the boxes straight into the trunk of my car. I’ll then take them directly to the bank and deposit the 5-grand. Since it’s a cash deposit, the money is available instantly so I will head back home, hop online, and pay my Southwest VISA bill using my debit card. What’s left on my end? Risk-free airline miles at very little cost, that’s what. Rinse and repeat as quickly as possible as many times as possible until the US Mint catches on and starts limiting the orders to $1,000 every 30 days per card/address and also charging $12.95 per 100 coins for shipping & handling. They’ll also start charging $1.12 per $1.00 coin. Maybe that’s why you never see those coins in circulation?
Scenario #3 – Value Added Arbitrage:
This one is not quite as sexy since in this scenario we don’t make money or get anything for free, but we do lock in a pricing discount that is not offered by traditional channels, and we do so at no cost. If a company offered you a $100 gift card for $87 would you think “hey, pretty good deal”? If a guy was selling $1 bills for 87 cents, would you buy one? Of course you would – you’d buy all you could get your hands on!In action > Say I’m at Target and they have a promo where they are selling a box of cookies for $3.99 with a free $5 Target gift card thrown in. Look past the cookies, and look closer at the arbitrage – you’ll see what they are doing is selling $5 Target gift cards for $4.36 ($3.99+tax) which is a 13% discount (essentially $1 being sold for 87 cents). Well if you shop at Target all the time, why not take their no-risk 13% savings offer? Sir, how many boxes of cookies do you have on the shelf? Ok, 290? I’ll take them all… 290 x $3.99 = $1,157.10 + tax = $1,264.14 paid for $1,450 in gift cards. I can arbitrage my way into a 13% discount on anything I buy at Target for the foreseeable future and take the cookies to Second Harvest Food Bank where others may enjoy them. Winner, winner, chicken dinner! Act quickly because Target will soon make the offer eligible only to those buying four boxes of cookies instead of just one (or I’m wondering if they just mis-printed the sign…)
Here are some popular scenarios these days where folks try to earn a living, or at least a profitable side-hustle business via arbitrage. If you like shopping (I hate it) and cleaning houses / changing bed linens (I hate it) then these might be for you…
Hustle#1 – Retail arbitrage through Amazon FBA (Fulfillment by Amazon) is a thing. It is a program where you send products to Amazon warehouses and they store and sell them for you. Amazon will handle your inventory and customer service issues, and your products will be sold on Amazon & Amazon Prime. Your job is merely to find real arbitrage opportunities – products selling for less than you can sell them on Amazon minus commissions and fees. Folks hit up discount retailers like Wal-Mart, Dollar Tree, Toys R Us, or alternative sellers like thrift stores, Cragslist, and flea markets looking for low-priced deals on items that can be re-sold at a significant mark up on Amazon, where they can command a higher price to a broader market. These arbitrageurs buy low, sell high, and pocket the spread in pricing discrepancies. It’s time consuming, requires a lot of shopping, and a lot of market knowledge to know the pricing on Amazon versus the price in front of you on the shelf.
Your risk here? Fast competition. It’s a popular hustle and the market can move against you when you have a trunk full of Guardian of the Galaxy toys and Amazon gets flooded by other sellers. Then what? Where do you unload them beside the dump?
Hustle #2 – Airbnb works by arbitrage. Say you have an apartment downtown that rents for $1,500/month. Similar spaces rent for around $150/night on on Airbnb when you’re only paying $50/night for your pad. Why does this pricing discrepancy exist? Folks needing short term lodging want something more economical than a hotel that can easily run $300/night. Airbnb serves that market. It allows property managers to capitalize on their real estate by listing their units at a rate higher than their daily cost of the unit, but still less than the nightly rate of a comparable hotel room, providing them a willing market to sell in to.
Want to figure your arbitrage rate? Find comparable Airbnbs in your area and take the average weekday rate times 5 plus the average weekend rate times 2. Divide that total by 7. (Weekday Rate x 5 + Weekend Rate x 2) / 7. Let’s say places near your pad go for $125/night on weekdays and $200/night on weekends. You’d have $625+$400 = $1,025/7 = $146 (a weighted average)
Now take your monthly payment of your house, condo, or apartment and divide by 30 (that would $50 x 30 in the example above for a $1,500/month payment). Finally, divide the weighted average Airbnb rate by your daily rental cost (146/50 = 2.92).
If the ratio is 1:1 you’d have to rent out your pad every day to cover your cost (not a good proposition), so the higher the ratio the better. Folks obtaining units they will dedicate solely to the rental market will want to see a ratio that is 2.5 or higher – so in our example (2.92) means you should move out, sleep in a tent, and Airbnb full time as this would be a very good rental arbitrage opportunity!
Your risk here? Vacancies. Your property costs will continue even when your unit is not rented, eating into your profits. Sleeping in a tent downtown can be risky too.
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Ok – there it is. A primer on arbitrage – my favorite form of investing & making money. Keep your eyes out for opportunities of risk-free or near risk-free gains as you make your moves like a Man on the Move. When everyday arbitrage presents itself, then act like an arbitrageur and pounce! As Warren Buffet says, “When it’s raining gold, reach for a bucket!” – Cheers!