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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. 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 ₹100 in Stock Market X and ₹101 in Stock Market Y. If the trader buys 10,000 shares of Company P in Stock Market X and then immediately sells them in Stock Market Y, then there will be a profit of ₹10,000 (if one excludes brokerage and other additional charges).
This was a quintessential example of arbitrage in the stock market. However, there are different types of arbitrage strategies practised in the real world. This article covers the different types of arbitrage strategies.
Table of Contents
Arbitrage in the Indian Share Market
Before examining various forms of arbitrage, it’s crucial to dispel a common misconception about arbitrage trading in India. Traders in the Indian stock market can’t sell shares bought on one exchange (e.g., NSE) on another (e.g., BSE), and vice versa. To sell shares intraday on the BSE, one must either purchase them on the BSE or already hold them in their demat account.
Suppose a price difference for a stock between the NSE and BSE is noticed, with it trading at ₹105 on the NSE and ₹100 on the BSE. Despite the temptation, one can’t exploit this arbitrage opportunity by buying on the BSE and selling on the NSE due to regulatory restrictions. However, if the stock is already in the Demat account, it can be sold on the NSE for ₹105 and promptly repurchased on the BSE for ₹100.
Nevertheless, traders can engage in arbitrage by purchasing stocks on a US exchange and selling them on a European exchange.
Types of Arbitrage
Pure Arbitrage
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.
Futures Arbitrage
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. 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.
Dividend Arbitrage
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.
Merger Arbitrage
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. Consider that there are two companies, Q and R, where Q trades at ₹400 and R trades at ₹90. As per the terms of the merger, the companies released a joint statement stating that for every 4 shares of R, one gets 1 share of Q. However, 4 shares of R would cost ₹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 ₹40 if the prices of Q and R stay the same until the shares are merged.
Retail Arbitrage
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
Requires Large Capital
To trade an arbitrage opportunity and profit from a minor price difference, one has 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 one has the capital, one should take note of the transaction fees, as the trade won’t make sense if the transaction fees exceed the profits.
Limited Opportunities
Finding arbitrage opportunities as a retail trader is challenging since regular traders don’t have hi-tech trading software at their disposal.
Conclusion
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 in 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.