What is Arbitrage Trading?
Arbitrage trading is a trading strategy that capitalizes on short-term price variations between two identical or equivalent assets in different markets to earn a profit. This is done by buying and selling the two assets simultaneously. Arbitrage trading is a derivative of the oldest trade trick in the book – using price differences for the same or similar goods or assets in two independent markets to make money. On the face of it, arbitrage trading sounds exploitative, but in reality, it is considered an effective way to iron out market inefficiencies i.e. ensure that all equivalent assets converge at the same price.
For markets to be perfectly efficient, opportunities for arbitrage trading should not exist, and by encouraging arbitrage trading regulators ensure that the imbalance between prices of the same or similar assets across different markets is forced to reach an equilibrium. Individuals that partake in arbitrage trading are called arbitrageurs.
Types of Arbitrage:
When an asset is selling at two different prices in two markets, for example, NSE in India and stock exchange in the US, an opportunity of pure arbitraging occurs. These trades are significantly profitable and can happen between any two markets across the world. To cash on these opportunities, large institutional trading firms use sophisticated software that automates the entire process.
This price difference lasts only for a short period. Usually, it disappears when more traders try to capitalise on the opportunity. Also, the price differs only by a few points after the decimal, so to realise a profit, traders need to trade in large volume, which makes it difficult for retail investors to capitalise on arbitraging opportunities.
The difference between pure arbitraging and risk arbitrating is the risk factor. In pure arbitraging, the profit gets booked the moment the trade initiates. But during risk arbitraging, the situation can change with the influence of certain market factors.
In risk arbitraging, the risk amount is often measured and when done correctly, can work at the trader’s benefit.
An arbitraging opportunity occurs when there is a potential of corporate takeover or merger. Merger and acquisition is a process when a big company takes over a small or underperforming firm. At the possibility of acquisition, the stock prices of the undervalued company can go up – creating a short price gap in the market.
If the company stocks are selling at Rs 10 against its actual value of Rs 12, then the trader can take the opportunity to arbitrage.
Another risk arbitrage opportunity occurs during pair trading. It is a situation when the stocks of two companies from the same sector with similar historical performance are selling at different prices. The trader sells the high-value company stocks and purchases the undervalued stocks in anticipation that stock prices will go up.
Risk arbitrage opportunity also happens when there is a possibility of company liquidation. The success of the trade depends on successfully identifying an undervalued company that might get liquidated. In such an event, the liquidation value of the company is usually higher than its market value. A trader can profit from this favourable price difference.
Cash-future arbitrage opportunity occurs from an unusual price difference between cash and futures prices in the market. In a cash-future arbitrage, the trader sells a futures contract that is trading at a premium (or buy one which is selling at low) and simultaneously, buys (sells) shares of equivalent quality. The difference between the prices is his profit. How does this difference in price happen? Well, usually at the beginning of the month, cash price and the futures prices of an underlying vary. This difference in price is called basis (cash price – future price), which traders exploit to create an arbitrage opportunity.
The price difference at the beginning of a month is a phenomenon observed often by F&O traders. They noted that although futures trading at the spot market at a premium (Contango) can sometimes also sell at a discount (Backwardation). There are certain events which can trigger this situation – one is the declaration of dividend by the company. A difference in spot price as against future price is indicative of market sentiment – widening of discount hints a bearish market whereas, widening premium denotes bullish trend.
You would need to train your eyes to spot possible arbitraging opportunities that occur when the price of a futures contract slips from premium to backwardation. This usually happens around the time of dividend declaration, when either the dividend is declared or is impending. If traders anticipate the dividend to remain consistent with the last year’s amount, then the futures price may slip to backwardation, with the discount percentage matching the dividend amount.
Another unusual situation that will present a trading opportunity is when there is backwardation happening due to heavy selling in the market. If there is an increase in open interest (OI) and volume but no substantial activity shift in terms of delivery percentage, you can assume that all the actions are taking place in the future market, creating an opportunity for arbitraging.
Retail arbitrage is a fairly common trade practice of buying goods from cheaper markets and reselling them in more expensive markets at a profit.
This type of trade involves buying convertible security and short selling the underlying stock in order to earn a profit.
Negative arbitrage refers to the difference between the interest rate a borrower is paying on debt and the interest rate at which that sum is invested.
Examples of Arbitrage Trading
The easiest way to understand the underlying business acumen of arbitrage trading is through an example. An arbitrageur owns stocks of a cross-border company called XYZ Limited trading at INR 15. The stocks of the same company are listed on another exchange trading at INR 10. The arbitrageur buys the stock of the company trading at INR 10 and sells the stocks he owns at INR 15. In this way, the trader earns INR 5 per stock.
Arbitrage trading is also done in foreign exchange. Using the difference in currency pairs and trading quickly to monetize price variations can yield tidy profits per trade. Again, the key is to act quickly and have a clear strategy formed prior to executing trades.
Is arbitrage good for financial markets?
Arbitrage trading creates liquidity in the financial markets. For the same or equitable assets being valued differently, it facilitates an equilibrium that is necessary for markets to function equitably. If a stock or asset is being undervalued in one region, exchange, or market, large volume arbitrage trades take the value up by purchasing them in large volumes. The same stock that is being overvalued in another market gets dumped, driving the price down. In this way, the price of dual-listed stocks is equalised.
What are the benefits of arbitrage?
Arbitrage trades entail profits at extremely low-risk exposure because buying and selling are done simultaneously to capitalise on the price variations. The trade is triggered with the intention of booking a fixed profit by trading in large volumes of shares. There is a chance that other traders capitalising on the same arbitrage opportunity would drive prices up and down unfavourably. Hence time is of the essence in arbitrage trades and is executed and managed by hedge fund managers and financial institutions that you can invest through.
Reliable and sophisticated systems manage arbitrage trades
Speed, large sums of money, and huge volumes of stocks are involved in arbitrage trading. Arbitrageurs rely on sophisticated and highly efficient computer software to identify arbitrage opportunities by detecting minuscule price variations and executing a trade of buying and selling stocks in the thousands in order to have the option of booking a handsome profit.
Safe and swift trades
Arbitrage trades are made surely and swiftly by smart trading software that is impervious to human intervention or error. They are short-term investments that are low risk and have the potential to guarantee profits, taking advantage of an existing price discrepancy and capitalising on it with speed and efficiency. There is no cash exposure and is unaffected by market forces that cause price fluctuations even on an hour-to-hour basis.
Is Arbitrage Trading in India legal?
In India, interexchange arbitrage is not legal. However, if you take delivery of securities before selling them on another exchange or partake in cash – futures arbitrage, inter-exchange arbitrage is allowed. What this means is as long as you don’t execute an intraday trade while arbitraging, you are in the clear. Executing manual trades for retail investors is tough because arbitrage trades are both time and price sensitive.
To book a decent profit in arbitrage, you need to act fast and trade in large volumes which requires the movement of large amounts of capital. In theory, retail traders can arbitrage stocks or other financial instruments across different brokers but for all practical purposes, such trades are difficult to execute. There is a reason why highly intelligent software systems are deployed to detect and carry out such trades which are used by even professionals and experts in the field.
For retail investors in India who don’t have the experience to execute arbitrage trades, there is an opportunity to invest nonetheless by placing money in arbitrage funds that participate in arbitrage but also invest in equity-based stocks. Such funds are treated as equity mutual funds (65% or more of the fund invest in equity) and are treated as such for the purpose of taxation.