Arbitrage is considered one of the primitive investment strategies in the stock market. An arbitrage strategy refers to the procedure of concurrent buying and selling of an asset from diverse platforms, exchanges, or locations to take advantage of price differences. The quantity of the underlying item purchased and sold should match when entering an arbitrage deal.
The only thing that is recorded as the trade’s net profit is the price difference. The pay-off should be sufficient to cover the transaction expenses associated with carrying out the deals. If so, the trader’s decision to start the transaction in the first place would be absurd.
Know more about Arbitrage
The practice of earning money by trading certain currencies, equities, and commodities on two distinct marketplaces is known as arbitrage. The price differences of the same product on two distinct exchanges or marketplaces provide a profit opportunity for arbitrageurs.
It is a method that benefits from market inefficiencies. In two or more separate markets, the price of the same good, money, or asset varies. By drawing attention to flaws, it indirectly enhances the markets. However, the arbitrageurs’ profits end as soon as the market achieves such improvements.
How does Arbitrage Function?
Arbitrage strategy refers to the practice of buying and selling stocks from different exchanges or markets to gain small profits. Here spread means the difference in price between two separate markets or exchanges in regard to a specific asset, commodity, or currency. This is called arbitrageur’s profit.
Arbitrageurs discover price issues for a particular stock while trying to capitalize on market ineptitude. As a result, markets actually get better. As a result, the arbitrageurs’ profits disappear as soon as the market becomes better.
Large financial institutions that invest significant quantities of money in the buying and selling of commodities, assets, or currencies are known as arbitrageurs. They operate in two separate markets. Furthermore, the arbitrageur needs to complete many transactions in order to earn a profit because prices do not fluctuate in inefficient marketplaces. Arbitrageurs must thus continually look for fresh opportunities.
Types of Arbitrage
There are different types of arbitrages in India, Like:
Pure Arbitrage: The trader chooses to purchase and sell simultaneously while not withholding any funds.
Retail Arbitrage – Retail arbitrage is when traders purchase goods at a discount and then resell them to customers for a profit.
Future Arbitrage – Cash is used to purchase the stock, which is then exchanged on a futures exchange. Futures are frequently priced higher than the cash price to reflect the future premium. At expiry, both prices converge, resulting in an arbitrage profit for the trader.
Risk Arbitrage – Investors typically acquire and keep stocks in the hopes that they will rise in value, blocking their money. The investors are essentially expecting a price gain in a separate market.
Merger Arbitrage – Merger arbitrage is the practice of buying a target company’s shares when traders have cause to think that the target company will shortly be purchased or merged. When the price increases following the merger, they sell the shares.
Dividend Arbitrage – When buying these kinds of stocks, investors do it just before the ex-dividend date. By the ex-dividend date, the investor must finish purchasing the underlying shares. Only at that point is the trader eligible to get paid on the designated day.
Major Benefits of Arbitrage Global Trading
Below are some of the main advantages of Arbitrage Trading.
- Minimal risk: By using potential low-risk buy-and-sell opportunities, arbitrage funds can produce short-term gains.
- Increased returns: compared to savings accounts: Arbitrage funds offer the potential to increase returns compared to a savings deposit account. They can produce consistent profits even in erratic market circumstances.
- Investors: have two options for allocating their money to arbitrage mutual funds: the lump amount mode and the systematic investment plan (SIP) option. With the former, people may put their full investment into a fund at once. By using the SIP option, one may invest in the top mutual funds for arbitrage by making set payments at regular intervals. While the minimum investment amount for the lump payment method is Rs. 1,000, the minimum investment amount for the SIP method is Rs. 500.
- Taxed as equities funds: For tax reasons, arbitrage funds are considered equity funds. It’s because at least 65% of the assets in these funds are equity shares.
Reason Behind Arbitrage
Arbitrage is a direct result of stock market ineptitude. Lower valuation or excess valuation of a stock may come out of inefficiencies for several reasons, including transaction cost, specific choices, or improper information. The likelihood of seeking arbitrage would not prevail if the market tends to function efficiently.
However, there are other forms of arbitrage strategy. Arbitrage can be either pure arbitrage or risk arbitrage, depending on the level of risk involved. Since it only occurs when a trader is aware that there is a price difference, pure arbitrage is risk-free. The forex market may be used as a source of inspiration for such an arbitrage. True or pure arbitrage occurs when a forex trader buys or sells currency pairs based on their current exchange rates.
Risk arbitrage includes investors or traders assessing the likelihood of a potential future occurrence and is based on that likelihood. Because equities are bought during a merger and acquisition, risk arbitrage is also known as merger arbitrage.
How arbitrage happen?
There are three scenarios in which arbitrage can 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 marketplaces because if the prices for the same commodity are the same, the arbitrageur may not be able to benefit.
- Prices may vary depending on which markets do better than others. For instance, the price for an identical asset on the Shanghai Stock Exchange may be different from that on the Stock Exchange during a downturn.
- 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.
How arbitrage is calculated?
One easy and effective way to do arbitrage calculation is to consider an example. The capacity of the trader to profit from the price difference of the same item in multiple marketplaces is a prerequisite for engaging in arbitrage trading. A majority of traders use computers to execute arbitrage transactions due to the short duration of these changes.
Let’s look at an illustration of how stock market arbitrage operates to better understand. Assume stock ABC is traded on both the London Stock Exchange (BSE) and the National Stock Exchange (NSE). On the BSE, the price of XYZ is quoted in pounds, whereas the NSE quotes the same price in Indian rupees. ABC trades at £4 per share on the London Exchange. The share price is Rs 238 on the NSE. The share price of ABC on the London Exchange in INR will now be Rs 240 if the GBP/INR exchange rate is Rs 60. In this case, when translated from GBP to INR, the identical stock is listed at Rs 238 on the NSE and Rs 240 on the London Stock Exchange.
A stock trader will purchase shares of ABC at Rs 238 per share on the NSE and sell the same number of shares for Rs 240 on the London Exchange to take advantage of the arbitrage opportunity, making Rs 2 per share in profit. While engaging in arbitrage transactions, traders must consider various risks. The price discrepancy is caused by an advantageous exchange rate, which is constantly changing. Losses may result from any significant fluctuation in the currency rate while the deal is being carried out. The transaction fees are a further crucial consideration. The benefit of the price disparity will be lost if the transaction costs are more than Rs 2 per share.
How does the work of arbitrage take place in India?
There aren’t many businesses that are listed on both Indian and international stock markets. However, there is a chance for arbitrage since India has two important exchanges—the BSE and the NSE—and the bulk of firms are listed on both. Even if a given share’s price differs between the NSE and the BSE, one cannot simply engage in an arbitrage transaction. On the same day, traders are not permitted to purchase and sell the same stock on separate markets. For instance, you cannot sell shares of ABC on the BSE the same day that you purchase them on the NSE. So how does arbitrage function?
A person can purchase the same number of shares from one exchange and sell shares that they already own in the DP on another exchange. If you currently own shares of ABC, for instance, you can sell them on the BSE and purchase them on the NSE. If you already own the stock, you are not engaging in illegal intraday trade on two distinct exchanges. The futures market presents a good chance for arbitrage, and two different types of methods, reverse cash and carry and cash and carry, are frequently employed there.
A trader who uses the cash and carries arbitrage trading method opens a short position on the commodity’s futures contract while going long on the underlying asset in the spot or cash market. It is an arbitrage trading method when an asset’s future price is higher than its present spot market price. The flip of cash and carry takes place when it comes to reverse cash and carry arbitrage.
Important Tips on Arbitrage Trading
Below are some of the proven tips on arbitrage trading.
- If exchange-to-exchange trading interests you, it entails purchasing on one exchange and selling on another. If you already have stocks in your Demat account, you can accept them. You should keep in mind that there are not always opportunities for arbitrage when there is a little price differential between the two exchanges. You must observe the exchanges’ bid price and offer price and note which is greater. The offer price is the cost at which people are selling their shares, and the bid is the cost at which they are ready to purchase.
- As previously indicated, if you are looking at futures-based arbitrage, you must consider the price differential of a stock or commodity between the cash or spot market and the futures contract. Prices in the spot market might range significantly from the future price during periods of high market volatility; this variation is known as the basis. The potential for trading increases with basis size.
- Transaction costs, which may frequently be high in the share market and offset any arbitrage profits, must be monitored in order to avoid losing money.
- Traders frequently monitor their cost of carry, or CoC, which is the expense they incur for holding a particular position in the market until the futures contract expiry. The cost of retaining an asset in its physical form is known as the CoC in the commodities market. When the futures are trading below the cash market value of the underlying asset, the CoC is negative. When a reverse cash and carry arbitrage trading method is in use, this occurs.
- Due to the price disparity between the cash and derivatives markets, there may be an arbitrage opportunity when a business announces any merger.
- When a corporation announces a share repurchase, you can use buyback arbitrage since there can be a discrepancy in price between the trading price and the buyback price.
What are transaction costs?
Traders should consider transaction costs while evaluating arbitrage possibilities. Costs may be high and maintained that way to prevent trade. If these charges are substantial and levied on every share traded, they could eliminate earnings. You must make transactions across marketplaces and become knowledgeable about price disparities if you want to understand what arbitrage in the stock market is. The fact that pricing disparities across marketplaces are often small is a key consideration when using an arbitrage strategy. If investors have a big sum available to engage in just one deal, arbitrage can only be effective to a significant extent.
Risks Associated With Arbitrage Trading
Like other types of trading, arbitrage global trading also comes with certain risks including:
- High transaction costs: Making a trade is not advantageous if the costs are greater than the gains. The Arbitrage strategy is not considered lucrative for small-scale investments.
- Opportunity gaps: It is quite challenging to find arbitrage possibilities without the use of tools.
- Considerable investment needed: Arbitrageurs must make significant financial investments in order to turn even a little profit.
- Market ambiguity: Sometimes, markets respond differently than anticipated. One can lower the spread by purchasing and selling a specific investment across many marketplaces. The likelihood of traders experiencing losses as opposed to gains might be significantly lowered.
Best Arbitrage Trading Opportunities in India
To maximize profits for investors, arbitrage funds use the price differential of equity shares between two marketplaces. These schemes’ fund managers simultaneously acquire shares on the cash market and sell them on the derivatives market. The best arbitrage opportunities can be defined as mutual funds’ returns that may be calculated by deducting the cost from the selling price. These funds are considered hybrid funds since a substantial percentage of their corpus is invested in debt securities.
|Fund||Type||Associated Risk||1Y Returns|
|Invesco India Arbitrage Fund||Hybrid||Low||7.20%|
|Tata Arbitrage Fund||Hybrid||Low||6.70%|
|Edelweiss Arbitrage Fund||Hybrid||Low||6.70%|
|Kotak Equity Arbitrage Fund||Hybrid||Low||6.80%|
|Nippon India Arbitrage Fund||Hybrid||Low||6.70%|
|Axis Arbitrage Fund||Hybrid||Low||6.40%|
|HSBC Arbitrage Fund||Hybrid||Low||6.50%|
|Aditya Birla Sun Life Arbitrage Fund||Hybrid||Low||6.60%|
|Bandhan Arbitrage Fund||Hybrid||Low||6.70%|
|ICICI Prudential Equity Arbitrage Fund||Hybrid||Low||6.60%|
|UTI Arbitrage Fund||Hybrid||Low||6.40%|
|Baroda BNP Paribas Arbitrage Fund||Hybrid||Low||6.40%|
|DSP Arbitrage Fund||Hybrid||Low||6.70%|
|Union Arbitrage Fund||Hybrid||Low||6.30%|
|SBI Arbitrage Opportunities Fund||Hybrid||Low||7.00%|
Briefly said arbitrage trading is a very effective approach that enables traders to profit on price differences. It provides traders with a number of benefits, but one must also be aware of any hazards connected to a certain trading technique. It must be remembered that developing the best market knowledge possible, having the capacity to act quickly, and exercising the greatest discipline are all requirements for success in arbitrage trading.
FAQs – Arbitrage Trading
1. What are the three prerequisites for arbitrage trading?
Ans. Technically, arbitration is feasible when any one of the three requirements is true.
a) The Law of No One Price is the basic need for arbitrage. The trading of the same item at the same price across all markets must be prevented. To put it another way, two assets that have comparable or identical cash flows cannot trade at the same price.
b) A futures-priced asset cannot trade today at a future price that has been reduced by the risk-free interest rate. That would be the ideal price and eliminate all chances for arbitrage.
c) To prevent exposure to market risk, or the risk that prices may change in the interim, arbitrage can only take place if both transactions can be completed at the same time.
2. Is arbitrage trading advantageous?
Ans. There are several ways through which arbitrage trading can lead to positive outcomes.
a. Arbitrage traders try to boost their earnings while enhancing the efficiency of the financial markets. When assets are bought and sold, the price differences between similar or equivalent assets become less.
b. Arbitrage is undoubtedly a low-risk investment.
c. Arbitrage promotes technological innovation and institutional engagement, which boosts market liquidity.
3. Can regular investors choose to engage in arbitrage trading?
Ans. Yes, arbitrage trading by private investors is completely legal in India. Prior to technological advancements and improvements in the accessibility of the financial markets, arbitrage trading was only available to institutional and professional traders. However, these developments have made it possible for retail and individual investors to actively engage in arbitrage trading and make sizable profits.
4. Do I need a specific license to engage in arbitrage trading?
Ans. No, you do not need to have a particular license in order to engage in arbitrage trading. However, it is important to keep in mind that SEBI (Securities and Exchange Board of India) and other organizations centrally oversee trading on the financial market. Therefore, dealers must make sure they adhere to the standards and structure created by the relevant regulatory organizations.