Arbitrag

This doesn't seem a particularly appropriate forum to create this thread, but given the general nature of the topic, I couldn't find one more suitable.
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There is much discussion around the arbitrage that would occur if brokers offered prices wildly out of line with each other, but I have to confess, I don’t get how it would work in practise.

If someone (Broker-A) was willing to sell at a price lower than someone else (Broker-B) was willing to buy, I can see how you’d buy all you could get your hands on from Broker-A and sell it on at the higher price to Broker-B. Technically, you’re flat. But it’s not like a physical product where you’ve passed it on from A to B, you still have two open positions: A long with Broker-A and a short with Broker-B. You’ve locked in a profit on the deal but you’ve still got two positions open. How do you wind them down?

Also, the bid/offer presumably has to be ‘outside’ on either the offer/bid or bid/offer for this to be workable. If Broker-A is at 130.20/25 and Broker-B is at 130.10/40 no arbitrage is possible as neither is selling at a lower price than the other is willing to buy – Broker-A is ‘inside’ Broker-B. Have I got that right?

I thought I'd try and answer this and then thought better of it as I'll only muck it up! But this gives you the gist of how it works: Investopedia Arbitrage Video

The way to look at it is that broker A might have their prices out of whack, or broker B or both brokers - you may not necessarily know. So, you might win on one trade and lose the spread on the other but come out in front across the pair - or make a little on both trades. barjon does the risk version of this (as described in the video) between the FTSE and the DOW: Barjon's Money Machine
Tim.

How the hell is that second example in the video considered to be an arbitrage trade? Looks like you're long a takeover to me and if the takeover hit's the sh1tter you're gonna be out of pocket... There's no hedge in place to ensure that you don't lose on the outright and so you have a theoretical unlimited risk. I'd have that is in start contrast to the concept of arbitrage.

Barjon's method is based on the mean reverting historic correlation relationship between FTSE and DOW isn't it? While I agree that there being an inherent risk accepting element is obvious, I fail to see how it draws any parallels whatsoever with the method explained in the video. It's not information based for a start as he looks only at the statistical likelihood of normalisation of the 'relationship' based on nothing more than the 'gap' when that itself is inferred by a number of variables i.e. FX, flows, index composition, etc.

Thanks timsk, but I'm none the the wiser. Lovely graphics, but no content that addresses my confusion.