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What is arbitrage
Tuesday, January 21, 2020
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What is arbitrage?

In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices.

When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit. A person who engages in arbitrage is called an arbitrageur—such as a bank or brokerage firm. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies.

However, it is also used when referring to sports betting markets and the technique of taking advantage of differences in price found from bookmaker to exchange to bookmaker.

A simple example

Imagine a golf match. Ladbrokes gives Tiger Woods odds of 10/11 and Oliver Wilson odds of 1/1. You couldn't make a profit by betting on both players at Ladbrokes.

What if we visit Paddy Power and they're offering Tiger Woods odds of 4/6 and Oliver Wilson odds of 7/5. Again you couldn't bet on both players at William Hill and make a profit.

However on a total investment of £100, if you placed £42 on Oliver Wilson at Paddy Power at odds of 7/5 and also £58 on Tiger Woods at Ladbrokes at odds of 10/11 you would be guaranteed a profit of over 6% of your total stake no matter which player won.

What we have done above is exploited the difference in prices between two bookmakers and created a combination of bets to exploit the difference.

Another way of thinking about it is as ‘cheap money’. Imagine if you could by £100 for only £95. You would make an instant £5 profit. This is effectively what arbitraging is all about.

With the bookmakers now in competition with the exchanges opportunities do arise for the arbitrageur. However, it is worth bearing in mind that arbitrage is hard work and returns are hard to find. But it is worth knowing about for those times when opportunities present themselves.

Arbitrage opportunities tend to occur in markets with small fields. Say a game of golf, a tennis match or a football match. A small price movement in small fields can create a significant imbalance when comparing the field in different markets.

Let’s look at another example.

Imagine we are looking at the prices in a tennis match. Roger Federer is priced at 1.92 digital odds and Andy Murray is available elsewhere for 2.12 digital odds. And we have £100 to ‘invest’.

The implied probability of Roger winning is 1/1.92 = 52.08%.
The implied probability of Andy winning is 1/2.12 = 47.17%.

This is a total of 99.25%. But it is 100% certain that one of these will win. So we can realise a profit in this scenario.

Here’s how:

We back Roger Federer at 1.92 and our stake will be £52.08
We also back Andy Murray at 2.12 and our stake will be £47.17

No matter the outcome we will win £100. But our outlay is only £99.25.

So we can guarantee £0.75 before the match has even started! It may not sound like much but the return on your £100 is much greater than you would get in even the most generous of high-street savings accounts in a single day!
Other arbitrage opportunities may crop up from time to time. For example, if you saw the price of something is 4/1 in the bookmakers but it is being offered at a lower price on the betting exchanges then all you need to do is back at the bookmakers and lay it off on the exchange at the lower price (remember to take into account your commission rate if the prices are tight).

One thing to be aware of is that some bookmakers will restrict your betting or stop taking your bets altogether if they think you are performing arbitrage. Often, people arbing with bookmakers will use multiple accounts with the same bookmaker to get around this. This is known as ‘wearing a beard’.

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