Arbitrage is a popular trading strategy that takes advantage of the price difference between different markets or financial securities. It most commonly entails buying a financial instrument in one market and then simultaneously selling it in another market at a higher price. The difference in the price of the asset in the two markets is the profit of the arbitrageur, a label used to describe traders performing arbitrage. This price difference may seem small; however, when traded in large quantities, even the smallest profit margins may result in impressive profit numbers.
Arbitrage opportunities can be found in various asset classes, including equity, commodity and currency. So if we had to explain the concept with the help of an example, assume the stock of Company A trades on Stock Market X and Stock Market Y. It trades at Rs. 100 in Stock Market X and Rs. 101 in Stock Market Y. So if the trader buys 10,000 shares of Company P in Stock Market X and then immediately sells them in Stock Market Y, then they’ll be going home with a profit of Rs. 10,000 (if you exclude brokerage and other additional charges).
That said, this was a quintessential example of arbitrage in the stock market. However, there are different types of arbitrage strategies practised in the real world. So, in this article, let us cover the different types of arbitrage strategies.
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Arbitrage in the Indian Share Market
Before looking at the different types of arbitrage, it’s essential that we clear up a common misconception regarding arbitrage trading in India. If you are a trader in the Indian stock market, you cannot sell shares on the BSE if they were bought on the NSE, the same trading, and vice-versa. To sell shares on the BSE intraday, you must buy them on the BSE or already have them in your demat account.
So suppose you notice a difference in the share price of a stock on the NSE and BSE; the share trades at Rs. 105 on the NSE and Rs. 100 on the BSE. Don’t think that you can perform arbitrage and profit from the price discrepancy by buying it on the BSE and immediately selling it on the NSE since the Indian Stock Market prohibits this. However, if you already have the stock in your demat account, you can sell it on the NSE for Rs. 105 and then immediately buy the same quantity on the BSE for Rs. 100.
That said, a trader can purchase stocks trading on the US exchange, sell them on a European exchange, and perform an arbitrage.
Types of Arbitrage
Now let us look at the different types of arbitrage in the financial market.
Pure arbitrage is the type of arbitrage discussed above, where the buyer simultaneously buys and sells a security in different markets, buying stocks of Company P in Stock Market X and selling them in Stock Market Y for a higher price. For example, buying a stock trading on the New York Stock Exchange and selling it on the Japanese Stock Exchange. Pure arbitrage is also common in the forex market due to price discrepancies in the exchange rates. Arbitrage involving forex trading is also called financial arbitrage. When executing a pure arbitrage, the arbitrageur does not block their funds.
Here, the arbitrageur executes an arbitrage trade by purchasing an asset like a cash market stock and then selling that asset's futures. This type of arbitrage is referred to as “cash and carry” arbitrage. This type of arbitrage is possible when the price of the asset in the futures market is greater than its price in the cash market. That said, the converse is also possible, which is called reverse cash and carry arbitrage. Here, the arbitrageur buys the futures of an underlying asset and then short-sells the asset in the cash market.
To perform this kind of arbitrage trade, arbitrageurs buy shares before the ex-dividend date and buy puts in the appropriate proportions. This type of arbitrage is also called an options arbitrage strategy.
A merger arbitrage can be performed when there is a merger of entities, like two publicly listed companies. To avoid complicating things, let us understand merger arbitrage with the help of an example. So consider that there are two companies, Q and R, where Q trades at Rs. 400 and R trades at Rs. 90. As per the terms of the merger, the companies released a joint statement stating that for every 4 shares of R, you get 1 share of Q. However, 4 shares of R would cost Rs. 360, and, therefore, this merger opportunity gives rise to an arbitrage opportunity. By holding 4 shares of R, the arbitrageur can make a profit of Rs. 40 if the prices of Q and R stay the same until the shares are merged.
This type of arbitrage is not seen in the stock market but is seen in physical markets selling goods. Retail involves arbitrageurs buying goods from a local merchant at a low price and then selling them to another merchant, online or offline, at a higher price to make a profit from the difference.
Risks of Arbitrage
Before concluding, it’s essential that we also understand the risks and shortcomings of arbitrage strategies. Below are some of the main risks involved with arbitrage strategies.
Requires large capital:
To trade an arbitrage opportunity and profit from a minor price difference, you have to invest or trade with a large capital. Most retail investors do not possess such capital and cannot take advantage of an arbitrage opportunity.
High transaction fees:
Even if you have the capital, take note of the transaction fees, as the trade won’t make sense if the transaction fees exceed your profits.
Finding arbitrage opportunities as a retail trader is challenging since regular traders don’t have hi-tech trading softwares at their disposal.
To conclude, traders can find arbitrage opportunities due to market discrepancies but need to consider a number of factors before they move forward to capitalise on the opportunity. At the same time, it is essential they are well-versed with the components of the arbitrage, especially if it involves derivatives. There are different arbitrage strategies that one can execute in different markets, but these opportunities may not be suitable for every investor profile.