How Arbitrage Trading Works?

What is arbitrage?

Arbitrage can be defined as the simultaneous buying and selling of the same asset in different markets to gain from the difference in price in both the markets. While arbitrage opportunity can arise in any asset class that is traded in different markets in a standardised form, it is more common in currency and stock markets. Arbitrage opportunities are often short-lived, lasting only a few seconds or minutes. Contrary to popular economic beliefs, markets are not completely efficient, which gives rise to arbitrage opportunities. The price of an asset is a result of the demand and supply in the market. Due to a discrepancy in supply and demand of an asset in different markets, a difference in price arises, which can be utilised for arbitrage trading.

How does arbitrage trading work?

Arbitrage trading is dependent on the ability of the trader to capitalise on the price differential of the same asset in different markets. Since arbitrage opportunities are very short, most traders use computers to conduct arbitrage trades. Let us understand with an example of how arbitrage works in the stock market. Let us assume that a stock XYZ is listed on the National Stock Exchange and the New York Stock Exchange. The price of XYZ is quoted in US Dollar on the NYSE, while the same is quoted in INR on the NSE. The share price of XYZ on NYSE is $4 per share. On the NSE, the share price is Rs 238. Now, if the USD/INR exchange rate is Rs 60, the share price of XYZ on the NYSE in INR will be Rs 240. In this situation, the same stock is being quoted at Rs 238 on the NSE and Rs 240 on the NYSE, if the USD is converted to INR.

To exploit the arbitrage opportunity, a trader will buy the shares of XYZ at Rs 238 per share on the NSE and sell the same number of shares at Rs 240 on the NYSE, earning a profit of Rs 2 per share. Traders have to take into account certain risks while participating in arbitrage trades. The price differential is a result of a favourable exchange rate, which remains in constant flux. Any substantial change in the exchange rate while the trade is being executed can lead to losses. Another important factor to take into account is the transaction charges. If the transaction cost exceeds Rs 2 per share, it will nullify the advantage of the price differential.

How does arbitrage work in India?

There is a lack of companies that are listed on the Indian stock exchanges as well as on foreign exchanges. However, India has two major exchanges—BSE and NSE—and a majority of companies are listed on both the exchanges, creating a potential for arbitrage. Even if there is a difference in the price of a particular share on the NSE and BSE, one cannot simply do arbitrage trade. Traders are not allowed to buy and sell the same stock on different exchanges on the same day. For instance, if you buy the shares of XYZ on NSE today, it cannot be sold on the BSE on the same day. Then how does arbitrage work? One can sell shares that he/she already has in the DP on an exchange and buy the same amount from a different exchange. For example, if you already have the shares of XYZ, you can sell them on BSE and buy them from the NSE. If you already have the stock, it is not an intraday trade on different exchanges, which is not allowed. 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 that 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.

When Does Arbitrage Take Place?

• An asset may have two separate market values, giving rise to two values that are not equal. There must be a price differential across markets because if the prices for the same commodity are the same, the arbitrageur may not be able to benefit.
• There could be a chance of price disparities in the different markets as a result of the performance. Hence giving arbitrageurs an opportunity to enter.
• Over time, stocks and other commodities may appreciate in value, or they may initially trade at a loss. The inefficiencies of the market present a chance for arbitrage.

Types of Arbitrage

Let us understand the types of Arbitrage in the financial market.

• Pure Arbitrage: Pure arbitrage is the strategy where the buying and selling of security takes place in different markets. The buying of stocks of company XYZ  takes place in Stock Market A, and the sale of those stocks takes place in Stock Market B for a higher price. 
• Futures Arbitrage: This type of arbitrage is generally known as  “cash and carry” arbitrage. Under this arbitrage strategy, the securities are bought with cash and sold in the futures market, as futures are usually priced higher than cash to account for the future premium. 
• Dividend Arbitrage: Arbitrageurs buy shares before the ex-dividend date and buy puts in the suitable proportions to perform dividend arbitrage. This type of arbitrage is also called an options arbitrage strategy.
• Merger Arbitrage: The merger arbitrage opportunity can be found in case of any acquisition or merger. In this strategy, the stocks of the target company are purchased and sold after the merger when prices increase.
• Retail Arbitrage: This kind of arbitrage is not available in the financial market as it is a popular e-commerce activity. The goods are bought at a low price from a local merchant and sold to another merchant via different channels online or offline at a higher price to make a profit from the difference.
• Risk Arbitrage: Under this strategy, the Arbitrageur anticipates a rise in the price of security and frequently buys and holds the stock. 
• Convertible Arbitrage: This strategy involves arbitrageur making profits from holding a long position in convertible securities and shorting the underlying stock.

Benefits of Arbitrage

There are numerous benefits of arbitrage, a few of which are listed below:

• Low-Risk Element: The risk element in arbitrage is next to nil or at least close to zero. 
• Better Price Discovery: Arbitrage effectively removes price variations between marketplaces and aids in the better price discovery of an asset.
• Benefits to Markets: Arbitrage supports making efficient and robust financial markets. In the absence of arbitrageurs, the stocks would have kept trading at different prices in different markets and, as a result, giving traders an unfair advantage. 
• Liquidity: Arbitrage makes markets more liquid as it invites institutional participation and the use of sophisticated technology.

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 that 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 a 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 asset 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.

Risks in Arbitrage

• You require a high amount of capital to trade an arbitrage opportunity and profit from a minor price difference. Due to less capital, most retail investors cannot take advantage of an arbitrage opportunity.
• Arbitrage transactions carry higher transactions that sometimes exceed your profits. 
• Since retail traders do not have access to sophisticated trading algorithms, it might be difficult to identify arbitrage possibilities.

Conclusion

Automated systems are generally used for arbitrage trading as the price differential doesn’t hold for a long time. Though it is easy to spot an arbitrage opportunity, manually profiting from them is very difficult and requires large investments.

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