Capital markets have various types of participants who employ different types of strategies to earn a profit. One can buy or sell within a day following the broader market trend or buy at a lower price and hold for a long term. All these strategies are executed with the aim to generate a profit. These types of trades are executed in the same market, but you can also profit by using the price differential of the same asset in different markets.
What is arbitrage?
According to mainstream economic theory, capital markets are efficient systems. The efficiency of the capital markets ensures that an asset will be priced the same in all the markets. The reality is slightly different though. Due to a variety of factors like different perceptions of the same asset in different markets or the difference in structures and functioning of different markets, sometimes a differential is created in the price of the same asset traded in different markets. When a trader exploits the differential, it is known as arbitrage trading.
What is arbitrage trading?
The price differential of the same asset in different markets is known as arbitrage and profiting from the differential is known as arbitrage trading. To understand arbitrage meaning, it is important to understand the mechanism behind arbitrage. The price of an asset is the function of demand and supply. Due to some inbuilt efficiencies of the stock exchanges, minor monetary glitches arise for a short time. Traders wait to gain from the glitches.
The mismatch in the level of demand and supply of security on different exchanges leads to a discrepancy in price, which is utilised by arbitrage traders. In typical arbitrage trade, the traders sell the asset in the market where the price is higher while simultaneously buying the asset in the market where the price is lower. Arbitrage trading seems to be a complicated process, but in reality, it is a simple, risk-free trade. Many traders use an automated system to execute arbitrage trades. The system automatically spots price discrepancies and executes the trade before it becomes common knowledge and the market corrects itself.
What is arbitrage in stock market trading?
Arbitrage opportunities are known to frequently arise in forex trading, but arbitrage trading is not unknown in stock markets too. Does the question arise what is arbitrage trading in the stock market? Arbitrage trading in stock markets is generally possible only in the case of stocks that are listed on multiple exchanges and that operate in different currencies. For instance, a company ABC is listed on both the BSE and the New York Stock Exchange. The shares of ABC are trading at $3 on the NYSE, while the price on the BSE is Rs 148. Let us consider the Dollar/INR exchange rate to be Rs 50, which means $1 = Rs 50. At the given exchange rate, the price of the stock on the NYSE in INR will be Rs 150. An opportunity for arbitrage trading arises as the same stock is priced at Rs 150 on the NYSE and Rs 148 on the BSE. In the situation, an arbitrage trader would buy the stock on the BSE and sell the same number of shares on the NYSE, making a profit of Rs 2 per share.
While arbitrage trades are considered to be riskless moves, there are certain limitations and risks nevertheless. Arbitrage trading opportunities do not remain active for a very long time. Arbitrage trading itself balances the chances of an arbitrage opportunity as increased demand can rectify the price discrepancy. While arbitrage trading, the trader assumes the risk of price volatility. A sudden rise in the price of the asset in the market with a lower price may level the price and lead to losses.
The question of what is arbitrage trading remains relevant only due to the inefficiencies in the market. Arbitrage traders also have to ensure that the transaction costs remain low as the price differential is often low and a high transaction cost will offset the arbitrage difference. Arbitrage trading opportunities cannot be predicted and have to be capitalised on short notice. If done right, arbitrage trading can be a relatively simple and risk-free activity.