What is arbitrage trading and how does it work?

A trading method known as arbitrage involves simultaneously purchasing and selling assets on several exchanges in an effort to profit from price differences. Traders that prefer risk-free trading might take advantage of market inefficiencies to make quick money. Let’s learn more about this tactic.

What is Arbitrage?

Arbitrage is the simultaneous purchase and sale of the same asset in two marketplaces in an effort to profit from the price discrepancy between them. Arbitrage opportunities can occur in any asset type that is traded across markets in a standardised manner, although they are more prevalent in the stock and currency markets.

Let’s see with an example

A trader, Karan is searching for arbitrage possibilities and techniques to make rapid profits. A stock called XYZ is traded on the NYSE (New York Stock Exchange) and the BSE (Bombay Stock Exchange). A stock’s price on the NYSE is $5, whereas it trades for Rs. 370 on the BSE.

Let’s assume that $1 Equals 75 INR at the current US/INR exchange rate. Using this computation, the share price of the ABC stock on the NYSE would be equal to Rs. 375 in Indian Rupees. XYZ is priced at Rs. 370 on the BSE at the same time.

Karan, who has access to both markets, may purchase the stock on the BSE for Rs. 370 and sell it on the NYSE for Rs. 375, generating a profit of Rs. 5 on each share traded. The foreign currency rate, as well as the underlying demand and supply factors in both markets, generate favourable chances for arbitrage trading.

Conditions Required for Arbitrage

Here are two prerequisites for engaging in arbitrage trading in India:

1.   Mismatch in asset price

For arbitrage to occur, the same asset must trade at different prices in various marketplaces.

2.   Simultaneous transaction

The trader should purchase and sell assets in many marketplaces at the same time. Because an arbitrage window is only available for a short period of time, the sooner a deal is completed, the better the chances of profit.

Transaction Fees

Arbitrage potential should be considered by traders who consider transaction fees. Costs may be kept high in order to limit trade. If these charges are substantial and levied every share traded, they could eliminate profits. To understand what is arbitrage in the stock market, you must make transactions across markets and learn about price differences. The fact that price differences are often modest across marketplaces is a crucial feature of implementing arbitrage as a strategy. Arbitrage can only function to a large extent if investors are willing to put a big amount of money into a single deal.

How does arbitrage work in India?

There is a scarcity of firms in India that are listed on both the Indian and overseas stock markets. As a result, the scope for arbitrage in foreign exchange is quite limited. The bulk of listed firms is traded on India’s two major stock exchanges, the NSE and the BSE. This opens up opportunities for arbitrage for traders interested in Indian stock markets.

But there’s a catch to the tale. Trading in the same stock on several exchanges on the same day is prohibited by SEBI, the regulatory body for the Indian capital market. As a result, engaging in arbitrage trading is difficult. A trader might engage in arbitrage in this situation by offering to sell shares of stock that are already in his Demat account on one exchange. In that case, the trader might purchase the identical quantity from a different exchange.

For instance, the same number of XYZ shares can be sold on the BSE and purchased on the NSE. This procedure isn’t regarded as an intraday trade.

Arbitrage is a fantastic way for risk-averse traders to benefit from stock markets. However, transaction costs and the limited window of opportunity to execute the trade are additional issues that traders must consider before pursuing arbitrage trading.

 

About the Author

Ketan Sonalkar (SEBI Rgn No INA000011255)

Ketan Sonalkar is a certified SEBI registered investment advisor and head of research at Univest. He is one of the finest financial trainers, with a track record of having trained more than 2000 people in offline and online models. He serves as a consultant advisor to leading fintech and financial data firms. He has over 15 years of working experience in the finance field. He runs Advisory Services for Direct Equities and Personal Finance Transformation.

Note – This channel is for educational and training purpose only & any stock mentioned here should not be taken as a tip/recommendation/advice

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