What is Arbitrage Trading?

Arbitrage trading is a trading strategy that capitalizes on short-term price variations between two identical or equivalent assets in different markets to earn a profit. This is done by buying and selling the two assets simultaneously. Arbitrage trading is a derivative of the oldest trade trick in the book – using price difference for the same or similar goods or assets in two independent markets to make money. On the face of it, arbitrage trading sounds exploitative, but in reality, it is considered an effective way to iron out market inefficiencies i.e. ensure that all equivalent assets converge at the same price.

For markets to be perfectly efficient, opportunities for arbitrage trading should not exist, and by encouraging arbitrage trading regulators ensure that the imbalance between prices of the same or similar assets across different markets is forced to reach an equilibrium. Individuals that partake in arbitrage trading are called arbitrageurs.

Is arbitrage good for financial markets?

Arbitrage trading creates liquidity in the financial markets. For the same or equitable assets being valued differently, it facilitates an equilibrium that is necessary for markets to function equitably. If a stock or asset is being undervalued in one region, exchange, or market, large volume arbitrage trades take the value up by purchasing them in large volumes. The same stock that is being overvalued in another market gets dumped, driving the price down. In this way, the price of dual-listed stocks is equalized.

Types of Arbitrage

Broadly there are 5 different types of Arbitrage trades.


  • Risk Arbitrage

Risk Arbitrage is executed by hedge fund managers that trade in stocks of companies that are being merged or acquired. The stocks of the target company are bought while they short sell the stock of the acquirer company.


  • Retail Arbitrage

Retail arbitrage is a fairly common trade practice of buying goods from cheaper markets and reselling them in more expensive markets at a profit.


  • Convertible Arbitrage

This type of trade involves buying convertible security and short selling the underlying stock in order to earn a profit.


  • Negative Arbitrage

Negative arbitrage refers to the difference between the interest rate a borrower is paying on debt and the interest rate at which that sum is invested.


  • Statistical Arbitrage

This is a sophisticated type of arbitrage trading using algorithms to detect arbitrage opportunities between financial instruments in different markets.

Examples of Arbitrage Trading

The easiest way to understand the underlying business acumen of arbitrage trading is through an example. An arbitrageur owns stocks of a cross-border company called XYZ Limited trading at INR 15. The stocks of the same company are listed on another exchange trading at INR 10. The arbitrageur buys the stock of the company trading at INR 10 and sells the stocks he owns at INR 15. In this way, the trader earns INR 5 per stock.

Arbitrage trading is also done in foreign exchange. Using the difference in currencies pairs and trading quickly to monetize price variations can yield tidy profits per trade. Again, the key is to act quickly and have a clear strategy formed prior to executing trades.

What is the benefit of arbitrage?


  1. Low-Risk profit

Arbitrage trades entail profits at extremely low-risk exposure because buying and selling are done simultaneously to capitalize on the price variations. The trade is triggered with the intention of booking a fixed profit by trading in large volumes of shares. There is a chance that other traders capitalizing on the same arbitrage opportunity would drive prices up and down unfavorably. Hence time is of the essence in arbitrage trades and is executed and managed by hedge fund managers and financial institutions that you can invest through.


  1. Reliable and sophisticated systems manage arbitrage trades

Speed, large sums of money, and huge volumes of stocks are involved in arbitrage trading. Arbitrageurs rely on sophisticated and highly efficient computer software to identify arbitrage opportunities by detecting minuscule price variations and executing a trade of buying and selling stocks in the thousands in order to have the option of booking a handsome profit.


  1. Safe and swift trades

Arbitrage trades are made surely and swiftly by smart trading software that is impervious to human intervention or error. They are short-term investments that are low risk and have the potential to guarantee profits, taking advantage of an existing price discrepancy and capitalizing on it with speed and efficiency. There is no cash exposure and is unaffected by market forces that cause price fluctuations even on an hour-to-hour basis.

Is Arbitrage Trading in India legal?

In India, interexchange arbitraging is not legal.  However, if you take delivery of securities before selling them on another exchange or partake in cash – futures arbitraging, inter-exchange arbitraging is allowed. What this means is as long as you don’t execute an intraday trade while arbitraging, you are in the clear. Executing manual trades for retail investors is tough because arbitrage trades are both time and price sensitive.

Conclusion

Pure arbitrage trades are risk-free ways of making money in financial markets. You can arbitrage in a range of different securities – forex, stocks, and commodities. But to book a decent profit and for the trade to be worth your time, you need to act fast and trade in large volumes which requires the movement of large amounts of capital.

In theory, retail traders can arbitrage stocks or other financial instruments across different brokers but for all practical purposes, such trades are difficult to execute. There is a reason why highly intelligent software systems are deployed to detect and carry out such trades which are used by even professionals and experts in the field.

For retail investors in India who don’t have the experience to execute arbitrage trades, there is an opportunity to invest nonetheless by placing money in arbitrage funds that participate in arbitrage but also invest in equity-based stocks. Such funds are treated as equity mutual funds (65% or more of the fund invest in equity) and are treated as such for the purpose of taxation.