What is arbitrage in trading and how it works?

Arbitrage trading plays an important role in any robust capital market across the globe because if there are no arbitrage traders, the markets wouldn’t know about mis-pricings or work towards reversals of the same. Arbitrage strategy is mostly practised by informed and experienced traders who have the capability to manage risk and sufficient finances. With the mis-pricing existing in markets, such traders make small profits through substantial capital allocation. Arbitrage allows efficiency in pricing and also overall market functionality.

Here is everything you need to know about arbitrage in trading and how it works.

What is arbitrage?

Arbitrage is a trading strategy in which a trader buys a security from one market and sells it in another market. This practice helps exploit the “efficient market” assumption and make quick profits. The assumption states that security with similar returns and the same risks should be available at the same price across all markets.

How does arbitrage trading work?

Arbitrage trading requires the trader to have the knowledge and capability of capitalising on security price differentials across different markets. Such opportunities are very short-lived, therefore, traders mostly make use of technology to carry out arbitrage trades. 

Here is an example to understand how arbitrage works:

We know that Infosys stock is listed on both the National Stock Exchange and the New York Stock Exchange. The stock’s price is quoted on the NSE in Indian Rupees, whereas on NYSE, it is quoted in US Dollars. 

Suppose, on a given day, the stock’s price on NYSE is $20 per share. 

On the NSE, the stock’s price is Rs. 1,550. 

The ongoing USD/INR exchange rate is Rs. 77.7. 

In that case, the stock’s price in INR on the NYSE will be Rs. 1,554. Thus, the same stock is quoted at Rs. 1,550 on the NSE and Rs. 1,554 on the NYSE. 

An arbitrage trader can make the most of this price differential by buying the stock Rs. 1,550 on the NSE and selling it at Rs. 1,554 on the NYSE. This can result in a profit of Rs. 4 per share.

Arbitrage opportunities in the Indian scenario

While there are fewer Indian companies that may be listed on both Indian stock exchanges and foreign exchanges, the two Indian major exchanges, BSE and NSE, see most major companies being listed on them. This also creates various arbitrage opportunities. 

However, even if a price differential exists on any stock listed on both the NSE and BSE, a trader cannot indulge in the arbitrage trade. This is because traders cannot buy and sell a given stock on different exchanges on the same day. If a trader buys Reliance stocks on NSE today, he/she cannot sell them on the BSE on the same trading day. Then the question arises, how can one do arbitrage trading? 

Arbitrage trading can be carried out by first selling stocks on one exchange (provided one has them in the Demat account) and then buying the same quantity through another exchange at a lower cost. 

Know the cost of arbitrage trading

Traders who want to explore arbitrage opportunities must consider the transaction fees associated with such trades. Here, the overall cost can be considerably high, making the final profit value redundant. It is also important to note that arbitrage mostly fetches positive returns only when there is a significant amount of capital invested in a single trade. Hence, it may not be feasible for retail investors to opt for arbitrage trading.

Traders/investors must ensure that arbitrage trading always requires simultaneous buy and sell transaction execution for it to fetch returns. This too has to be done within a very short time period, lasting only up to a few minutes. Therefore, employing sophisticated trading tools online may be essential for arbitrage trading. 

Conclusion

Arbitrage can be one of the strategies for traders to explore profit-making opportunities while dealing in the stock markets. Relying solely on arbitrage can be risky and may result in losses. Retail investors may find it difficult to explore such opportunities. Hence, they can invest in arbitrage mutual funds if interested in benefiting from this form of trading.

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