How Arbitrage Trading Works?

Arbitrage trading exploits price differences across markets by buying low and selling high instantly, helping maintain market efficiency and fair pricing.  

Opportunities arise due to market inefficiencies, varying demand–supply levels, exchange restrictions, and temporary mispricing between spot, futures, or cross-exchange trades.  

Traders use strategies like pure arbitrage, futures arbitrage, merger arbitrage, and dividend arbitrage while managing costs, volatility, and execution risks.  

Arbitrage supports liquidity, accurate price discovery, and stable financial markets, though it demands high capital, fast execution, and awareness of transaction costs.  

An asset may have two separate market values, giving rise to two values that are not equal. There must be a price differential across markets because if the prices for the same commodity are the same, the arbitrageur may not be able to benefit. 

There could be a chance of price disparities in the different markets as a result of the performance. Hence, allowing arbitrageurs to enter. 

Over time, stocks and other commodities may appreciate, or they may initially trade at a loss. The inefficiencies of the market present a chance for arbitrage. 

Pure Arbitrage (also known as Spatial Arbitrage): Pure arbitrage is the strategy where the buying and selling of a security takes place in different markets. The buying of stocks of company XYZ  takes place in Stock Market A, and the sale of those stocks takes place in Stock Market B for a higher price.  

Futures Arbitrage: This type of arbitrage is generally known as  “cash and carry” arbitrage. Under this arbitrage strategy, the securities are bought with cash in the spot market and sold in the futures market, as futures are usually priced higher than cash to account for the future premium and cost of carry.  

Dividend Arbitrage: Arbitrageurs buy shares before the ex-dividend date and buy puts in suitable proportions to perform dividend arbitrage. This type of arbitrage is also called an options arbitrage strategy. 

Merger Arbitrage: The merger arbitrage opportunity can be found in the case of any acquisition or merger announcement. In this strategy, the stocks of the target company are purchased at a discount to the offer price and sold after the merger when the deal is completed at the agreed price. 

Retail Arbitrage: This kind of arbitrage is not available in the financial market, as it is a popular e-commerce activity. The goods are bought at a low price from a local merchant and sold to another merchant via different channels, online or offline, at a higher price to make a profit from the difference. 

Risk Arbitrage: Under this strategy, the Arbitrageur anticipates a rise in the price of a security and frequently buys and holds the stock. This term is generally synonymous with Merger Arbitrage, where the risk is that the proposed deal or merger fails to close. 

Convertible Arbitrage: This strategy involves an arbitrageur making profits from holding a long position in convertible securities and shorting the underlying stock to hedge the market risk. 

Low-Risk Element: The risk element in arbitrage is next to nil or at least close to zero.  

Better Price Discovery: Arbitrage effectively removes price variations between marketplaces and aids in the better price discovery of an asset. 

Benefits to Markets: Arbitrage supports making efficient and robust financial markets. In the absence of arbitrageurs, the stocks would have kept trading at different prices in different markets and, as a result, giving traders an unfair advantage.  

Liquidity: Arbitrage makes markets more liquid as it invites institutional participation and the use of sophisticated technology. 

If you are interested in exchange to exchange trading, it would involve buying in one exchange and selling in another. You can take it up if you already have stocks in your demat account, as intraday cross-exchange trading of the same stock is generally restricted by regulations in India. You would need to remember that the price difference of a few rupees in the two exchanges is not always an opportunity for arbitrage. You will have to look at the bid price and offer price in the exchanges and track which one is higher. The price that people are offering shares for is called the offer (or ask) price, and the bid is the price at which they are willing to buy. 

In the share market, there are transaction costs such as brokerage fees, STT, and exchange charges that may often be high and neutralise any sort of gains made by an arbitrage, so it is important to keep an eye on these costs. 

If you are looking at arbitrage where futures are involved, you would have to look at the price difference of a stock or commodity between the cash or spot market and the futures contract, as already mentioned. In a time of increased volatility in the market, prices in the spot market can widely vary from the future price, and this difference is called basis. The greater the basis, the greater the opportunity for trading (if the price relationship is irrational). 

Traders tend to keep an eye on the cost of carry or CoC, which is the cost they incur for holding a specific position in the market till the expiration of the futures contract. In the commodities market, the CoC is the cost of holding an asset in its physical form (including storage, insurance, and financing costs). The CoC is negative when the futures are trading at a discount to the price of the asset underlying in the cash market. This happens when there is a reverse cash and carry arbitrage trading strategy at play.. The CoC is negative when the futures are trading at a discount to the price of the asset underlying in the cash market. This happens when there is a reverse cash and carry arbitrage trading strategy at play. 

You can employ buyback arbitrage when a company announces a buyback of its shares, and price differences may occur between the trade price and the price of buyback price. A key consideration for retail traders is the acceptance ratio, which determines how many tendered shares the company will actually purchase. 

When a company announces any merger, there could be an arbitrage opportunity because of the price difference between the cash and the derivatives markets. This is a risk arbitrage strategy where the target company stock trades at a discount to the final offer price due to the risk that the deal might not close. 

You require a high amount of capital to trade an arbitrage opportunity and profit from a minor price difference. Due to less capital, most retail investors cannot take advantage of an arbitrage opportunity and must compete with large institutional traders using superior technology. 

Arbitrage transactions carry higher transaction costs that sometimes exceed your profits if not properly accounted for.  

Since retail traders do not have access to sophisticated trading algorithms, it might be difficult to identify and, more importantly, execute arbitrage possibilities before they disappear, which can happen in milliseconds.