What Is Arbitrage Trading And How Does It Work ?

Arbitrage is a trading strategy in which traders fix their profit by buying and selling identical financial assets, such as security, commodity, currency, etc., in different markets. Traders may buy a commodity from market A and sell the same in market B, as the price in market B is high. 

In simple terms, arbitrage is a process of buying an asset from one market and selling the same in the other market to get a higher yield. The difference between both the prices is the profit to a trader. It may seem difficult to the freshers, but experienced traders exploit this strategy to its best levels by trading in various markets.

This type of strategy shows the inefficiencies of the market, and traders take advantage of the same. Traders involved in the activity of arbitrage are called arbitrageurs. Arbitrageurs must have Automated Trading Software to check the arbitrage opportunity and make some profit. They usually work on behalf of huge financial corporations and institutions and trade large quantities.

The price of any asset is based on the demand and supply in the market. Now, there are chances that some commodity's demand and supply can be different in different markets and thus creates price indifference; this indifference gives birth to the arbitrage opportunity.

How does the Arbitrage Strategy Works ? 

Arbitrage depends on arbitrageurs' ability to profit from the price difference in the different markets. As this opportunity does not last for a longer period, thus traders rely on the softwares to execute the trade instantly.

Let us see an example of how arbitrage works.

Suppose an ABC stock is listed on NSE (National stock exchange), and the same stock is also listed on NYSE (NewYork Stock Exchange). The price of the ABC stock is INR on NSE and in USD on NYSE, respectively. Let's say the price on NYSE is $4, and on the NSE, it is Rs. 238. Considering the exchange rate (1 USD = 60 INR), the price on the NYSE becomes Rs. 240 ( 60 X 4 ). Notice here the same stock is available at Rs. 238 in the Indian stock market and Rs. 240 in the foreign market; NYSE. What the arbitrageurs will do here, he will buy at Rs. 328 from NSE and sell the same at Rs. 240 in the NYSE. Doing so will make a profit of Rs. 2 per share.

Things to note here:

• There are chances of loss.
• If the rate of conversion changes, you may not get the desired profit.
• If the transaction cost is more than Rs. 2 in this case, then it nullifies the execution of the trade, as there is no advantage of the price difference here.

There are some preconditions for arbitrage to take place as below:

Asset Price imbalance: It is necessary that the same asset is being traded at the different stock markets to gain the advantage of the price difference in both markets.

Simultaneous execution of buying and selling: The activity of buying and selling should be conducted simultaneously in order to get the benefit. Otherwise, even a second delay can turn the trade upside down.

How does Arbitrage work in India?

Few companies are listed on Indian and foreign stock exchanges, limiting arbitrage potential. However, we have two major stock exchange platforms in India, BSE and NSE. Many companies are listed on both exchanges. But there is a small rule here; you cannot arbitrage using these two platforms on the same day. Suppose you have bought the shares of ABC company from BSE and want to sell on NSE; you have to wait for 24 hours, till the next day, until there will be no room for getting the benefit of arbitrage, as it is short-lived. So, what to do? In such situations, there are Arbitrage Trading Strategies here Indian traders apply. If you already have the shares of ABC Company in your portfolio, you can sell them at a higher price and buy the new one at a lower price; you get your profit in the form of a difference.

If you are looking for lesser or no risk, then you may also try Option Trading Strategies for gaining the benefit of arbitrage by entering into options arbitrage trades.

So, we hope you must now clear with the concept of arbitrage and how it works. We have seen just one example, but there are more than 40 types of arbitrage in the financial market. A few of them include Triangular arbitrage, Index Arbitrage, futures arbitrage, options arbitrage, Tax arbitrage, Gold arbitrage, Beta arbitrage and many more. Let us know if you would like to know in detail about all the types of arbitrage. We shall provide you with all of them with examples in our coming articles.