How To Identify Arbitrage Opportunity

While trading in stocks, commodity, or currency, traders exploit different trading opportunities to optimise their profit. However, almost all trading types involve the risk of market exposure, but arbitraging is one such scope, which, if done in an ideal condition offer risk-free profit. It is an opportunity that occurs due to market inefficiency, where the price of the same underlying differs between two markets. Whether it is it legal to gain from price difference is a different debate but, in some economy, arbitraging is encouraged to identify market deficiencies. In India, arbitraging is allowed under certain circumstances.

Arbitraging involves simultaneously buying and selling of an asset in spot or future to earn a risk-free profit from price differences. Arbitraging opportunities arise due to market malfunction, which leads to overvaluation or undervaluation of an asset between two or more markets. It is a strategy adopted by traders for securities, currencies, or commodity to buy low and sell high.

We can categorise arbitraging in two main categories – pure arbitraging and risk arbitraging.

Pure Arbitraging

When an asset is selling at two different prices in two markets, for example, NSE in India and stock exchange in the US, an opportunity of pure arbitraging occurs. These trades are significantly profitable and can happen between any two markets across the world. To cash on these opportunities, large institutional trading firms use sophisticated software that automates the entire process.

This price difference lasts only for a short period. Usually, it disappears when more traders try to capitalise on the opportunity. Also, the price differs only by a few points after the decimal, so to realise a profit, traders need to trade in large volume, which makes it difficult for retail investors to capitalise on arbitraging opportunities.

Risk Arbitraging

The difference between pure arbitraging and risk arbitrating is the risk factor. In pure arbitraging, the profit gets booked the moment the trade initiates. But during risk arbitraging, the situation can change with the influence of certain market factors.

In risk arbitraging, the risk amount is often measured and when done correctly, can work at the trader’s benefit.

An arbitraging opportunity occurs when there is a potential of corporate takeover or merger. Merger and acquisition is a process when a big company takes over a small or underperforming firm. At the possibility of acquisition, the stock prices of the undervalued company can go up – creating a short price gap in the market.

If the company stocks are selling at Rs 10 against its actual value of Rs 12, then the trader can take the opportunity to arbitrage.

Another risk arbitraging opportunity occurs during pair trading.  It is a situation when the stocks of two companies from the same sector with similar historical performance are selling at different prices. The trader sells the high-value company stocks and purchase the undervalued stocks in anticipation that stocks prices will go up.

Risk arbitraging opportunity also happens when there is a possibility of company liquidation. The success of the trade depends on successfully identifying an undervalued company that might get liquidated. In such event, the liquidation value of the company is usually higher than its market value. A trader can profit from this favourable price difference.

Cash-Future Arbitrage

Cash-future arbitrage opportunity occurs from an unusual price difference between cash and futures prices in the market. In a cash-future arbitrage, the trader sells a futures contract that is trading at a premium (or buy one which is selling at low) and simultaneously, buys (sells) shares of equivalent quality. The difference between the prices is his profit. How this difference in price happens? Well, usually at the beginning of the month, cash price and the futures prices of an underlying vary. This difference in price is called basis (cash price – future price), which traders exploit to create an arbitraging opportunity.

The price difference at the beginning of a month is a phenomenon observed often by F&O traders. They noted that although futures trading at the spot market at a premium (Contango) can sometimes also sell at a discount (Backwardation). There are certain events which can trigger this situation – one is the declaration of dividend by the company. A difference in spot price as against future price is indicative of market sentiment – widening of discount hints a bearish market whereas, widening premium denotes bullish trend.

You would need to train your eyes to spot possible arbitraging opportunities that occur when the price of a futures contract slips from premium to backwardation.  This usually happens around the time of dividend declaration, when either the dividend is declared or is impending. If traders anticipate the dividend to remain consistent with the last year’s amount, then the futures price may slip to backwardation, with the discount percentage matching the dividend amount.

Another unusual situation that will present with a trading opportunity is when there is backwardation happening due to heavy selling in the market. If there is an increase in open interest (OI) and volume but no substantial activity shift in terms of delivery percentage, you can assume that all the actions are taking place in the future market, creating an opportunity for arbitraging.

Conclusion

Arbitraging opportunities can arise in any market. Most arbitraging opportunities occur due to market inefficiency or caused by factors that can influence the price, like in case of futures contracts, the dividend amount paid to be the deciding factor. Whatever is the matter, most arbitraging opportunities arise during crossover and divergence. You would need to train your eyes to identify such opportunities to trade.