Arbitrage is the term used to describe the simultaneous selling and buying of an underlying asset or its derivative in different markets. The difference in pricing between the asset in the two markets is what leads to an arbitrage opportunity, and a gain.
Arbitrage strategies arise simply because of the way the markets are built. There are inefficiencies in the market owing to lack of information and costs of transaction that ensure that an asset’s fair or true price is not always reflected. Arbitrage makes use of this inefficiency and ensures that a trader gains from a pricing difference.
Depending on the markets involved, there are different arbitrage strategies. There are strategies that relate to the options market and there are specific arbitrage strategies that refer to the futures market. There are also strategies for the forex markets and even retail segments.
The futures market lends itself rather well to an arbitrage opportunity, and there are two types of strategies commonly used in the futures market, including cash and carry and reverse cash and carry strategies. Cash and carry is an arbitrage trading strategy which involves a trader going long on an underlying asset in the spot or cash market and opening a short position on the futures contract of the asset. It is an arbitrage trading strategy wherein the price of an asset in the future is greater than its current price in the spot market. When it comes to the reverse cash and carry arbitrage, the flip of cash and carry occurs.
Arbitrage trading tips
Here are some tips to help you take up arbitrage trading:
– If you are interested in exchange to exchange trading, it would involve buying in one exchange and selling in another. You can take it up if you already have stocks in your demat account. You would need to remember that the price difference of a few rupees in the two exchanges is not always an opportunity for arbitrage. You will have to look at the bid price and offer price in the exchanges, and track which one is higher. The price that people are offering shares for is called the offer price, which the bid is the price at which they are willing to buy.
– In the share market, there are transaction costs which may often be high and neutralise any sort of gains made by an arbitrage, so it is important to keep an eye on these costs.
– If you are looking at arbitrage where futures are involved, you would have to look at the price difference of a stock or commodity between the cash or spot market and the futures contract, as already mentioned. In the time of increased volatility in the market, prices in the spot market can widely vary from the future price, and this difference is called basis. The greater the basis, the greater the opportunity for trading.
– Traders tend to keep an eye on cost of carry or CoC, which is the cost they incur for holding a specific position in the market till the expiration of the futures contract. In the commodities market, the CoC is the cost of holding an seet in its physical form. The CoC is negative when the futures are trading at a discount to the price of the asset underlying in the cash market. This happens when there is a reverse cash and carry arbitrage trading strategy at play.
– You can employ buyback arbitrage when a company announces buyback of its shares, and price differences may occur between the trade price and the price of buyback.
– When a company announces any merger, there could be an arbitrage opportunity because of the price difference in the cash and the derivatives markets.
Now that you know all arbitrage trading tips, particularly in the stock markets, you should always keep in mind, it’s time to go ahead and put them into practice. However, it helps to keep in mind that you need to understand the nature of an asset and the markets involved. So, if you are looking at the share market, you would need to understand the price difference of the stock in the cash market and its pricing in the futures contract, and learn to assess when you would initiate long or short positions.