What Is Arbitrage Trading Strategy in the Stock Market?

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In the world of trading, there are several methods of trading. Arbitrage trading strategy is one of the most discussed topics due to its nature and results. As trading evolves, people learn and improve their skills in trading. There is an advancement in technology that lets you access different trading indicators and strategies in the palm of your hand.

The concept of algo-trading has grown, and the complexity of these systems can only be handled by the technical trader or quant. So, in this article, we will discuss arbitrage trading. Arbitrage is one of the alternative investment strategies that, when used correctly, can be both beneficial and simple. 

However, it’s critical to understand the concept of arbitrage trading strategies. There are three types of arbitrage: pure arbitrage, convertible arbitrage, and merger arbitrage.

What is an Arbitrage Strategy?

Arbitrage is one of the easy-to-understand but hard-to-master strategies. In this strategy, traders take the profit from the market difference for the same asset. For the arbitrage strategy, it is vital to have a situation where at least two of the same assets have different prices in different markets.

In other words, an arbitrage is a situation where a trader makes profits from the imbalanced price of assets in different markets. The clear and simple strategy of arbitrage is purchasing an asset at a lower price and then selling it at a higher price but in another market.

This strategy was followed in ancient times when traders used to get goods from one part of the world to another. The trader who performs this trade is often known as the arbitrageur. The concept will not work in a perfect market, where the asset price will be the same in different markets. The difference in the price of assets provides an opportunity to trade in volume between two markets.

You can also say that arbitrage strategies occur in the mispricing of financial assets. Many professional investors hedge their investments and use this strategy to make better returns.

Types of Arbitrage

There are different types of arbitrage strategies. These are as follows:

Pure Arbitrage

A pure arbitrage investment strategy is one in which investors buy and sell financial assets in different markets with a price difference that is the trader’s profit. The arbitrage is also called pure arbitrage. Pure arbitrage is possible when there is a difference in exchange rates, which leads to pricing discrepancies and a small profit on differences.

Merger Arbitrage

Merger arbitrage is a risky type of arbitrage related to merging entities such as two publicly traded businesses. But in simple words, the merger consists of two parties. It will be the target company and the acquiring company that must purchase the outstanding shares of said company. So, in most cases, there is a premium on the stock that is traded for at the time of the announcement, making a profit for shareholders. This price of the share is discounted, and the acquiring company sells these shares in order to make a profit.

Convertible Arbitrage

Convertible arbitrage is a type of arbitrage that is related to convertible bonds. You can also refer to the convertible notes or convertible debt. A convertible bond is a type of bond in corporate debt that pays interest to the bond owner. 

The major difference between a convertible bond and a traditional bond is that in a convertible bond, the bondholder has the option to convert it into shares of the underlying company at a discount. Companies issue convertible bonds because doing so will allow them to offer lower interest payments, and investors who do convertible arbitrage will take advantage of the difference between the bond conversion and the current price of an asset.

To achieve success in this trade, you need to take simultaneous positions, i.e., long and short positions in the convertible bonds and underlying shares of that company. But before opting for the convertible bonds, you need to check whether they are fairly priced. If the bond is considered to be on the lower side, then take a short position on the stock and a long position on the bond. If the above scenario is reversed, you must take a long position in the stock and a short position in the bond.

What Is the Example of an Arbitrage Trading Strategy?

Arbitrage trading consists of buying and selling profit shares, commodities, or currencies on the individual market. In the financial world, the word arbitrage is often used for other trading purposes, such as an activity where a merger arbitrage, buying company shares prior to an announcement, or any expected merger.

To understand this trading concept, you can consider off-border opportunities. Suppose an international listed their share in a country like Canada, which is around CAD 20. But at the same time, the stock of the XYZ company is worth around USD 16. Depending on the current exchange rates, a trader can buy shares in the US market and then sell them in large quantities on the Canadian stock exchange. The difference of $4 or more, excluding the tax, will be the profit of the trader.

Why is Arbitrage Trade Important?

The goal of every trading strategy is to make a profit. Likewise, the arbitrage trade is an efficient strategy when there is a difference between two markets. As a trader buys and sells similar assets, the choice is quite narrow. The lower-priced assets are bid up, and the higher-priced assets are sold off. In this balancing of asset prices, the arbitrage resolves the efficiency of the market and adds liquidity to the market.

You can also use the automated system for arbitrage trading. In this strategy, you have to check for a differential and often go for a short-term trade. If everything goes well, as you set all the variables and conditions accurately, then you can achieve better results from the automated trade. You need to check various instruments and markets for this type of trade.

An arbitrage strategy is just one part; with a professional broker like Share India, you can get lots of trading strategies. Share India lets you trade smartly and equips your trade with top-notch technology. So, if you want to invest with experts, then join the Share India platform.

It has many forms and is also an effective tool for investors who are seeking low-risk yields. The reason for low yields is the high volume required to generate a small profit and overcome the transaction cost, which includes tax and other charges. But often, the hedge funds and other institutional investors are capable of high volumes.

Final Words

The arbitrage condition occurs when you can profit from the price difference of a financial asset in the individual market at the same time. According to the theory of arbitrage trading, trade will not be possible in a perfect market. However, the arbitrageurs identify the perfect gap and take advantage of the mispricing, which works to move prices back in line with market inefficiency.

So, as a risk-averse trader, you need to be sure that your trade is in safe hands. For an advice trading service, you can connect with Share India. It offers free trading and Demat account opening along with low brokerage charges.

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