What is Arbitrage Trading?

Arbitrage is the process of making revenue through a financial instrument's price variations across markets. The foundation of this procedure is that the assets need to be traded at the same price in every market. Arbitrageurs look to benefit from the brief deviations in these prices. Arbitrage aims to generate income by taking advantage of these slight differences. Experts define arbitrage trading as the simultaneous purchasing low and selling high across multiple markets. Arbitrages can be classified as temporal (price differences over time), geographical (geographic price differences), or statistical (price disparities based on statistical models). Let’s explore what is arbitrage trading in detail.

Examples of Arbitrage

To thoroughly understand how arbitrage trading functions in the Indian stock market, let's look at an example. Let's say you are an arbitrageur in the Indian stock market, and you observe a difference in pricing between the share price of Company X and other companies: 

• Price on the National Stock Exchange (NSE): The current price of a single share of Company X is ₹15,000 on the NSE. 
• Price on the Bombay Stock Exchange (BSE): At the same time, Company X's share is trading on the BSE for ₹15,020. 

In this case, the price differential for the same share on the NSE and BSE is ₹20 (15,020 - 15,000. An opportunity for arbitrage is available due to this price difference.

How Does Arbitrage Trading Work?

Now that you know the arbitrage trading meaning, let’s find out how to implement the strategy. Here is how arbitrage trading works. 

• Market Segmentation: The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are two major exchanges in the Indian financial markets. The price differences between various platforms could be beneficial, leading to potential returns. 
• Cash-futures Arbitrage: There may be a potential for arbitrage in the cash (spot) and futures markets. You can buy and sell the same stock at the same time in the cash market, as well as take opposite positions in linked futures contracts. By doing this, they can profit from the disparity in prices between the two markets. 
• Currency Arbitrage: Traders may want to look into this business because of India's multi-currency usage. To profit from differences in exchange rates, this entails trading foreign exchange or currency futures. 
• Technology and Connectivity: In India, technology plays an essential part in arbitrage trading. To find and take advantage of price disparities, traders require real-time data feeds, algorithmic trading tools, and high-speed internet access. Modern tools and dependable trading systems are necessary for effective arbitrage trading. 
• Regulation and Tax Implications: Indian arbitrage traders are subject to regulations related to insider trading, market manipulation, and exchange guidelines. To precisely calculate their profits, they must also be aware of the tax effects, particularly capital gains taxes.

Given that India uses several currencies, traders might also look at the chances of currency arbitrage.

Arbitrage Trading Process

Let’s learn about the arbitrage trading process by considering an example. 

Step 1: Purchase on Exchange with Lower Asset Price
Acting as an arbitrageur, you quickly purchase Company X shares on the NSE for the 
₹15,000 lower price. 

Step 2: Sell on Exchange with a Higher Asset Price
You simultaneously sell identical shares for ₹15,020 more on the BSE. 

Step 3: Calculating Profits 
You have now secured a profit per share of ₹20 (15,020 - 15,000). Your profit could increase if you accomplished this arbitrage with a sizable number of units. 

Step 4: Risk Management
Hedging techniques like purchasing options or futures contracts are used by arbitrageurs to reduce the risk of abrupt market movements against their position.

Step 5: Monitor Trades
Price differences can disappear quickly and other traders might be attempting to take advantage of them. Hence, arbitrageurs must constantly keep an eye out for such possibilities in the markets.

It's crucial to remember that these price discrepancies frequently result from changes in order routing, supply and demand, and trading regulations between various exchanges.

Why Is Arbitrage Trading Important?

Arbitrage traders improve the effectiveness of the financial markets while generating wealth. The price differences between comparable or identical assets get smaller when traders buy and sell them. Higher priced assets are sold off and the lower priced assets are bid up. Arbitrage provides liquidity to the market and fixes pricing inefficiencies in this way.

Types of Arbitrage Trading

Let's explore the different types of financial market arbitrage. 

1. Pure Arbitrage: Pure arbitrage is a method in which securities are bought and sold in separate marketplaces. Stock Market A is where company XYZ's equities are purchased, while Stock Market B is where those stocks are sold at a higher price. 
2. Futures Arbitrage: More commonly referred to as "cash and carry" arbitrage. Futures are typically priced higher than cash to account for the future premium. Hence, the securities are purchased using cash and sold in the futures market. 
3. Dividend Arbitrage: To engage in dividend arbitrage, investors purchase shares before the ex-dividend date and the purchase is put in the appropriate ratios. It is also called an options arbitrage strategy. 
4. Merger Arbitrage: In the event of a merger or acquisition, there is a chance for merger arbitrage. This tactic involves buying target company stock and selling it when prices rise following the merger. 
5. Risk Arbitrage: In this approach, the arbitrator often purchases and holds the stocks because they believe the security price will increase. 
6. Convertible Arbitrage: With this strategy, an arbitrageur can benefit by selling the underlying stock and maintaining a long position in convertible instruments.

Benefits and Drawbacks of Arbitrage Trading

Before you begin arbitrage trading in India, you must be aware of its key advantages and drawbacks. The table below highlights the major benefits and risks of this trading strategy.

Arbitrage Trading Tips

Here are some useful tips that can assist you with arbitrage trading.

• Properly track the bid and offer price to find out which is higher.  
• You should know that there is not always room for arbitrage when there is very little price difference between the two exchanges. 
• It's essential to monitor transaction costs in the share market as they can cancel out any arbitrage profits, which are frequently quite high.
• In arbitrage involving futures, you must consider the price difference of stock or commodities between the cash or spot market and the futures contract. 
• Monitor the cost of carry, or CoC, which is the cost of holding a position in the market until the futures contract expires.

Conclusion
Arbitrage trading entails generating profits from the price difference of securities. It can be an effective method in the share market. However, it calls for stringent risk management, the use of technology, and a thorough understanding of the market. You may explore potential arbitrage opportunities through a stock market app which provides access to several assets across various markets. However, adhere to all relevant regulations. To benefit from arbitrage in stock market trading, you must approach it with caution and expertise.