Understanding Arbitrage

Arbitrage is a unique concept. It allows traders to exploit price discrepancies for the same underlying at different markets. It is considered a relatively low-risk strategy compared to other trading tools, which is why it is common. But, is arbitrage trading legal? In some countries, arbitraging is not only permitted but encouraged too. It is an exciting concept, which we are going to discuss in this article and explain how arbitrage can be a trading strategy to diversify your portfolio.

What Is Arbitrage?

Arbitrage is an investment technique used by traders to earn profit from the price difference of an asset in different markets. It is an act of purchasing and selling the same security in different exchanges or benefiting from the price difference between the spot prices of a security and its future contracts. Arbitrage contributes to market efficiency. Moreover, arbitrageurs help improving liquidity in the market.

Market efficiency is a term used to describe competency of the market, that is the degree of availability of all relevant information regarding security price. If the market is operating at an efficient level, then all price information is already captured in the security price, and there are no oversold or overbought securities available.

Arbitrageurs contribute to market efficiency. How?

Arbitrageurs attempt to take advantage of price differences in different markets. Now if the market is efficient, ideally there shouldn’t be any price difference between different market. But arbitrageurs benefit from mispricing,  a clear violation of the law of one price. So, when arbitrageurs do so, they eventually bring the price discrepancy to the fore and allow other traders to benefit from it, adjusting the market for the new price.

Let’s dig deeper into the concept.

Arbitraging can happen in the market for any asset – stocks, commodity, or forex.  By engaging in arbitraging, arbitrageurs are also influencing liquidity in the market. Say for example – an arbitrageur is buying shares of a company at a lower price in market A and selling it at market B at a higher price. In doing so, they function as market intermediaries and adding liquidity to the market.

In most cases, arbitraging is considered risk-free or low in risk, but it isn’t entirely true. Arbitraging involves the chances of missing the arbitraging opportunity, which increase your risk exposure. Like, you have identified an arbitraging opportunity, but by the time you react to the chance, it may disappear.

Who Are The Common Players?

Anybody can take part in arbitraging, even retail traders. However, institutional players and mutual funds asset management companies dominate the market. They have the software that helps them identify arbitraging opportunities and carrying out the transactions fast, while a retail investor may struggle to capitalise on the prospect.

For retail investors who want to take advantage of arbitraging but lack expertise, can invest in mutual funds arbitraging funds.

Is Arbitraging Even Legal In The Indian Market?

There is one concept called inter-exchange arbitraging. In India, security prices differ, albeit by a tiny margin between the stock exchanges, creating arbitraging opportunities for traders. However, the current market policies bar traders from indulging in arbitraging during intraday trading. That is to say that arbitraging isn’t an intraday trading strategy. You’d need to reverse your position before day end and square off at the same exchange. But if you are taking delivery of the securities, you can open arbitraging opportunity for yourself. Also, it helps you trade risk-free. You can take stock delivery in one exchange and deliver in the other exchange.

Traders use several arbitraging strategies. One such policy is cash-futures arbitraging.

Suppose you purchased shares of company XYZ from the market at Rs 190 apiece and sold a futures contract for the same shares at Rs 215 in the futures market. Thus, creating a risk-free arbitrating opportunity.

Key takeaways

  • – Arbitraging arises from price differences of the same asset in different markets
  • – It isn’t an intraday trading strategy, and inter-exchange arbitraging  isn’t legal in India for intraday
  • – However, you can arbitrage between two exchanges if you are taking security delivery or participate in cash-future arbitraging
  • – Don’t confuse the last trading price of a security as an arbitraging opportunity

Conclusion

To summerise, arbitraging is an investment strategy that allows traders to gain from asset price differences in different markets. But it isn’t an intraday trading strategy. Traders use a plethora of arbitraging trading technique, but as more traders try to capture the price difference, it disappears. And to answer the question – is arbitrage trading legal in India? Yes, it is, if you are taking stock delivery.

Arbitraging is encouraged in many markets since it brings out price discrepancies and helps the market to implement the law of one price.