In the strict sense, simultaneously buying and selling equivalent exposures to capture a price difference with no net risk. In practice, the term covers trades with small but genuine residual risks.
True riskless arbitrage is rare and short-lived, because the act of exploiting it removes it. What is usually called arbitrage is relative value: a position that should converge for structural reasons, funded and hedged so that only the spread matters.
Every real arbitrage carries at least one of four risks: the spread widening before it converges, financing being withdrawn, the hedge behaving imperfectly, and the legal or corporate event underpinning the trade failing to complete. Leverage is normally applied because the spreads are small, which converts modest adverse moves into meaningful losses.
The 1998 failure of Long-Term Capital Management remains the standard illustration: positions that were individually sound converged eventually, but not before financing disappeared. See merger-arbitrage and convertible-arbitrage.
Original diagrams for the ideas on this page. Illustrative, not real market data.
The bid-ask spread. Buy orders sit below, sell orders above, and the gap between the best bid (50.01) and best ask (50.04) is the spread you pay to cross. Bar length shows the size resting at each price.Margin and leverage. A $5,000 deposit can control a $100,000 position, which is 20:1 leverage. Because the loss is measured on the full $100,000, a 2.5% move against you halves the deposit and brings a margin call, and a 5% move uses all of it.
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