What is Arbitrage Trading and how does it work?

Arbitrage is a trading method that has become increasingly popular over the years. Arbitrage can be done in shares, forex, commodities, and even cryptocurrencies. 

What is arbitrage?  

Arbitrage is a type of trading in which a trader tries to make money from the difference in the prices of similar financial instruments, typically listed on different trading platforms. 

These differences occur when different financial institutions set different prices for the same asset, such as the EUR/USD. This means that arbitrage trading is made possible when a person buys an asset from one financial institution at one price, and sells it almost immediately at another institution for a higher price. This is done to make money from the difference between the two prices. 

Due to the speed at which transactions are done, the trader's risk can be shallow. But there is always a risk when arbitrage trading, and significantly so if the prices change quickly or there needs to be more money to go around. 

How does arbitrage trading work? 

Arbitrage trading is made possible because financial markets are not entirely seamless or perfect, and has space for biases. The main factors that move the markets are supply and demand, and a change in either of these can affect the price of an asset. 

Arbitrage traders try to make money by taking advantage of short-term price inequality in the financial markets. They try to find price differences that can happen when the supply and demand on different exchanges differ. This helps the trader make a quick profit with relatively little risk. 

As part of an arbitrage trading strategy, traders can use an automated trading system to their advantage. Automated trading systems use algorithms to find price differences. This lets traders take advantage of a market opportunity before it becomes widely known, and the markets adjust. 

How does arbitrage work in India? 

There aren't enough companies listed on both Indian and foreign stock exchanges. India, on the other hand, has two significant domestic exchanges: BSE and NSE. Most companies are listed on both exchanges, which makes arbitrage a possibility. Even if the price of a particular share is different on the NSE and the BSE, you just can't just make an arbitrage trade. On the same day, traders can't buy and sell the same stock on different exchanges. For example, you can't sell shares of XYZ that you purchased on the NSE the same day on the BSE. So, then how does arbitrage trading work in India? One can sell shares in the DP on one exchange and buy the same number of shares on another exchange. For example, if you already own shares of XYZ, you can sell them on the BSE and buy them on the NSE. You are not engaging in a prohibited intraday trade across exchanges if you already hold the stock in question. 

The futures market is an excellent place to find arbitrage trading opportunities. Here, there are two types of strategies that are often used: cash and carry, and reverse cash and carry. Cash and carry is an arbitrage trading strategy in which a trader buys an underlying asset on the spot or cash market and sells its futures contract. It is a type of arbitrage trading in India in which an asset's future price is higher than its price on the spot market. In the reverse cash and carry arbitrage, cash and carry are turned around. 

Arbitrage trading tips 

What is arbitrage trading? If you want to get into arbitrage trading, here are some tips: 

• If you want to trade from one exchange to another, you would buy on one exchange and sell on another. You can use your Demat account if you already have stocks. You must remember that a few rupees price difference between two exchanges is not always a chance to make money through arbitrage. You will have to look at the exchange's bid price and offer prices. The price at which people are willing to sell shares is called the "offer price", and the price at which they are ready to buy shares is called the "bid price". 

• In the stock market, high transaction costs often cancel out any arbitrage trading gains. So, keeping an eye on these costs is essential. 

• If you want to arbitrage with futures, you have to look at the difference in price between the cash and spot markets of a stock or commodity, as well as in futures contracts. When the market is in a high state of volatility, the spot price can be very different from the futures price. This difference is called the basis. The more the basis, the greater the chances to trade. 

• Traders usually keep an eye on the cost of carrying, or CoC, the amount of money they have to pay to maintain a specific position in the market until the futures contract expires. CoC is the cost of holding an asset physically on the futures market. The CoC is negative when the price of the futures is lower than the price of the underlying asset in the cash market. This happens when a trading strategy called "reverse cash and carry arbitrage" is in play. 

You can use buyback arbitrage when a company announces a buyback of its shares. There may be a price difference between the market price and buyback prices. Also, when a company announces a merger, there may be an arbitrage trading opportunity because the cash and derivatives markets have different prices. 

Conclusion 

Arbitrage trading is a great way to trade and make money, and it works well with investments that change a lot, like cryptocurrencies. But before opening any new positions, investors must conduct a lot of research. Start small, and only invest your risk cushion at first. 

FAQs 

Q. What are the dangers of trading in arbitrage? 

Suppose XYZ Co is to be bought over by ABC Co. But if the deal doesn't go through for any reason, XYZ Co's stock price is likely to drop, possibly sharply, while the stock price of ABC Co would go up. If an investor is long on XYZ Co’s shares and short on ABC Co, the investor will lose money. 

Q. What makes arbitrage trades tough to execute? 

There are limits to arbitrage because of three types of risks: fundamental risk, noise trader risk, and implementation risk. Fundamental risk is simply the chance that arbitrageurs could be wrong about the fundamental values of their positions. 

Q. How do you know if there's a chance for arbitrage? 

Arbitrage can happen when an investor doesn't put any money into an investment but still expects to make money in the future, or when an investor gets a net inflow from an investment but still expects to make money or get nothing in return in the future.