What is Arbitrage?
Arbitrage is the practice of buying an asset in one market and simultaneously selling it in another, but at a higher price. As a result, the transitory difference in share price benefits the traders.
Stocks, commodities, and currencies are all used in arbitrage transactions. The scenario offers the trader the chance to benefit without taking any risks. The returns can be impressive when multiplied by a high volume, even though pricing variations are often tiny and transient. Arbitrage opportunities are frequently short.
What is Arbitrage Trading?
Arbitrage trading is the trading of assets across different markets when the price of the same asset is different in every market. Let’s understand with the help of an example:
A trader looking for arbitrage opportunities sees a stock ‘X’ trading for Rs. 500 per share at a market ‘A’.
On another market ‘B’, the trader sees the same stock ‘X’ trading at Rs. 600 per share.
He decides to buy 10 shares of stock ‘X’ from market ‘A’ and sell them on market ‘B’.
The trader makes a profit of Rs. 100 per share and makes a total profit of Rs. 1000 on selling 10 shares.
How Does Arbitrage Work in India?
A trader can sell shares on one stock exchange and then purchase identical shares on another exchange if one already has shares in a free demat account. Therefore, a trader can earn a profit if he sells at a higher price and purchases identical shares at a lower price.
Even if the share’s price differs between the NSE and BSE, one cannot simply engage in an arbitrage transaction. Traders are prohibited from transacting in the same stock on two different exchanges on the same day.
If the trader already has stocks in their demat account, they can engage in arbitrage trading by first selling them on one exchange and then purchasing the same quantity on a different exchange at a lower price. For example, a stock sold at Rs. 110 on the BSE and immediately purchased at Rs. 100 on the NSE, lowering the cost of holding.
The futures market offers a good arbitrage opportunity. When engaging in cash-futures arbitrage, the trader buys in the cash market and sells the same number of shares in the futures market. In India, stock futures have a monthly expiring cycle, which expires on the last Thursday of the month. One must purchase similar lot sizes in the cash market since futures trade in minimum lot sizes.
Types of Arbitrage
The following are the types of arbitrage:
- Pure Arbitrage: The trader decides to buy and sell at the same time without holding back any money.
- Retail Arbitrage: The traders buy products at a lower price and sell them to the consumer for a profit.
- Future Arbitrage: The stock is bought with cash and traded as a futures exchange. To reflect the future premium, futures are often priced higher than the cash price. Both prices converge at expiration, giving the trader an arbitrage profit.
- Risk Arbitrage: Investors frequently believe that a stock will increase in value, so they buy and hold it to block their funds. In essence, the investors anticipate a price increase in a different market.
- Merger Arbitrage: When the traders have a reason to believe that a target firm will soon be acquired or merged, they buy its stock. They sell the shares when the price lifts after the merger.
- Dividend Arbitrage: When investing in equities of this type, traders buy them immediately before the ex-dividend date. The investor must complete the purchase of the underlying stock by the ex-dividend date. The trader is only then qualified to receive the payout on the specified date.
- Convertible Arbitrage: Traders gain from taking both a short position in the underlying company and a long one in convertible securities. For example, currency.
Risks Involved in Arbitrage Trading
It is susceptible to the following shortcomings:
- Hefty transaction fees: Engaging in a trade is not beneficial when the transaction fees exceed the profit. Arbitrage is not a profitable idea when investing a small amount.
- Opportunities are limited: Finding arbitrage opportunities without the help of software is extremely difficult.
- Requires huge investment: To make even a tiny profit, arbitrageurs must invest a sizable sum of money.
- Market uncertainty: Markets occasionally behave differently than expected. When a given investment is bought and sold in many markets, one can reduce the spread. It can be drastically reduced that traders experience losses rather than gains.
Frequently Asked Questions
There are three requirements for arbitrage to take place:
1. The same asset is valued differently in various markets: An asset may have two different market values, leading to two different prices. A difference between marketplaces is crucial because if the prices for the same commodity are the same, it might not be possible for the arbitrageur to make a profit.
2. The trade prices of two assets with the same cash flow are different: Price differences may result from the performance of some markets being higher than that of other markets.
3. The price of an asset today differs from its known future price: A discounted price may initially be offered on the market for stocks and other commodities, but over time, their prices may rise. An arbitrage opportunity is created by the market’s inefficiencies.
Arbitrage can be beneficial in the following ways:
1. Arbitrage traders improve the effectiveness of the financial markets while they are working to increase their profits. The price discrepancies between identical or comparable assets get smaller when they buy and sell.
2. Arbitrage is certainly a low-risk trade.
3. Arbitrage encourages institutional participation and the use of cutting-edge technology, which increases market liquidity.
Note: An arbitrage lets the trader make only a minimal amount of profit. One should invest a substantial amount of money to earn a meagre profit. The cost deducted during the transaction shall also be taken into account.
The trader finds a market disparity or identifies an item whose value is lower in one market than in another. Arbitrageurs may work for financial companies that scan the market and swiftly profit from price discrepancies using algorithms or specialised softwares.
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