The term ‘arbitrage’ may seem confusing, but it’s similar to grabbing a great deal in the market before anyone else. It implies buying an asset in one market and then selling it in another market where the prices are higher. Traders look for market inefficiencies to make quick profits through arbitrage, which ensures balance in prices across different platforms.
This strategic approach exists in various forms, including merger arbitrage, spatial arbitrage, and statistical arbitrage. From currency markets to stock exchanges, arbitrage has a significant role to play in global trading.
Continue reading this blog to gain detailed insight into what is arbitrage, its types, benefits, drawbacks and more.
Arbitrage Trading Meaning
Arbitrage trading signifies the buying and selling of the same asset simultaneously in different markets to benefit from price differences. Arbitrage opportunities can arise in any class of assets traded in different markets, most commonly in the currency and stock markets. The opportunities of arbitrage trading are, however, short-lived and last only for a few minutes or even seconds.
In contradiction to popular economic beliefs, the majority of markets are not completely efficient, which thereby gives rise to arbitrage opportunities. The presence of demand and supply in the market determines the price of an asset. The prices change because of the discrepancies in demand and supply dynamics, which can lead to price differences and arbitrage trading.
Benefits of Arbitrage Trading
Here are the distinguishing features and benefits of arbitrage trading:
- Low Risk: This type of investment involves exploiting price disparities between two marketplaces for the same item to generate a sizable return with little to no risk.
- Effective Markets: Arbitrage contributes to the stability and effectiveness of financial markets. It guarantees that prices stay tightly linked across marketplaces and reduces the price difference between two distinct markets.
- Cross-Border Investment: In order to practice arbitrage, investors typically turn to international or cross-border markets. This promotes cross-border investments and aids in the integration of international markets.
- Liquidity: Institutional investors, who are crucial in supplying market liquidity, are invited to participate in arbitrage. Arbitrageurs facilitate the buying and selling of assets by increasing trading volume.
- Profit Opportunity: Another important benefit of arbitrage trading is the ability to capitalise on market price inefficiency. Traders can make profits easily and instantaneously by buying an asset at a lower cost and selling it in another market at a higher price without taking risks.
Drawbacks of Arbitrage Trading
The significant drawbacks of arbitrage trading are as follows:
- Transaction Cost: People frequently overlook the significant transaction costs associated with purchasing and selling assets. Furthermore, the revenue received from the asset’s sale is also subject to taxes. These two factors reduce the profit or occasionally cause a loss.
- Market Risk: The market fluctuates and is often steady. Taking simultaneous positions in many markets is known as arbitrage. Arbitrageurs may be exposed to market risk due to shifts in the market, which might result in losses.
- Capital Requirement: Traders need a substantial quantity of capital in order to profit from market price differences. This may make arbitrage strategies less accessible to smaller investors or businesses with low levels of capital.
- Technology: An arbitrageur has to be very active and knowledgeable about the state of the market. Technology is mostly used by arbitrageurs to obtain information and execute trades quickly. The arbitrageur may lose the chance if the execution procedure is hampered by a lack of technology, a bug, or a system breakdown.
How does Arbitrage Trading Function?
Let’s look into how arbitrage trading works actually:
- Arbitrage trading involves the capitalisation of inefficiencies in prices in different markets. Considering the advantage of differences in prices between two different markets for the same security, an investor can incur profits with no or minimal risk.
- Management of risks and execution are essential for easy navigation of complexities involved in arbitrage trading. Traders here must take transaction costs into consideration along with other additional expenses.
- To carry out arbitrage trading smoothly, having a good knowledge of the market is essential to adapt to market fluctuations.
- The steps involved in arbitrage trading are as follows:
- Identifying Discrepancies in the Market: This is the primary step, where a trader analyses different assets and market conditions and keeps track of the prices. Once the trader spots a price difference, he/she must place trades in both markets very quickly to generate profit.
- Purchasing of Assets: After the identification of a new opportunity, arbitrageurs must purchase the asset at a lower price. In the financial market, assets are further categorised as shares, bonds, commodities, currencies, etc. Arbitrageurs are the ones who purchase those assets in the market. Since arbitrage opportunities can be lost in little time, traders must place their orders very quickly.
- Selling of Assets: The arbitrageur sells the item at a higher price in another market as soon as he/she purchases it. By selling the item for more money, he/she makes a profit equal to the difference between the asset’s purchase and sale prices. However, the sale must take place within a fraction of a second from the purchase.
What are the Different Types of Arbitrage Trading?
The different types of arbitrage trading are as follows:
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Pure Arbitrage
Pure arbitrage or “arbitrage” is a common trading strategy. Pure arbitrage is a theoretically risk-free investment approach where the investor exploits market inefficiencies. In this case, the trader buys the asset at a lower price on one stock market and sells it at a higher price on other exchanges.
When an asset is exchanged on different marketplaces simultaneously without any delay, pure arbitrage takes place. Because it takes time for market players to learn and adjust to new information, traders must monitor the market and stay ready to place orders at a moment’s notice.
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Merger Arbitrage
An arbitrageur takes advantage of the differences in the share price of a company during the process of merger, takeover or acquisition. A merger of two or more companies, an acquisition or a takeover is generally considered to drive up the share prices of the parent company.
The trader buys the shares of the company before the realisation of a merger and sells them after. This is also called risk arbitrage as it’s not risk-free like pure arbitrage.
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Convertible Arbitrage
Convertible arbitrage involves the trading of convertible securities, such as convertible shares and bonds. Arbitrageurs may buy convertible bonds and short-sell the underlying stock, creating a hedge. Profits are made from the price discrepancy between the convertible security and the stock.
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Retail Arbitrage
The setting of retail arbitrage allows the arbitrageurs to exploit the price differences between multiple product segments. Retailers buy from one retail source and sell at a higher price in another retail channel to make profits.
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Spatial Arbitrage
In spatial arbitrage, the trader uses geographical locations to exploit price inefficiency. The arbitrageur buys the asset in one market at a lower price and sells it in another where the price is higher. This strategy allows traders to exploit discrepancies in less efficient markets where arbitrage opportunities arise.
Examples of Arbitrage Trading
Here are some common examples of arbitrage trading:
- For example, the National Stock Exchange (NSE) and the New York Stock Exchange (NYSE) both list shares of the ABC firm. The share price is stated at ₹40 per share on the NYSE and ₹350 on the NSE. The share price of XYZ will be ₹320 if the USD/INR exchange rate is ₹80 per dollar. The arbitrage trader would now buy XYZ shares on the NYSE for ₹320 and sell them on the NSE for ₹350. Each share will provide a profit of ₹30 for him.
- Although it is common in the securities market, arbitrage occurs in everyday life as well. Assume that Mr A buys 100 event tickets in bulk for ₹50 each, which he then sells for ₹60. He makes ₹10 on each ticket as a result, for a total of ₹1000.
Tips for Arbitrage Trading
Arbitrage trading might seem easy, but it’s also a challenging task. Trading requires years of practice and learning. Thus, if you are planning to go a step forward in arbitrage trading, here are the tips outlined you should follow to benefit in the long run. These tips will also enable you to incur higher profits in the long run. Let’s explore the tips below in detail:
- Gain a thorough understanding of the market dynamics
- Identify reliable sources of data
- Conduct research about trading and stay informed
- Develop different strategies for the management of risks
- Close monitoring of liquidity in the market
- Consider the different costs of transactions
- Maintain patience and discipline
- Abide by the trading regulations
- Rely on advanced trading platforms and different tools for automation.
Risks of Arbitrage Trading
While arbitrage trades are theoretically risk-free, there are several risks that traders have to bear in practice, including:
- First and foremost, arbitrage trading needs a large amount of capital. Arbitrage opportunities often deal with price differences, where large amounts should be invested to work on the trades to achieve good returns. Generally, individual investors do not have sufficient capital to justify interventions of these types.
- Secondly, transaction costs can be high. Arbitrage trading involves multiple transactions across different markets, and traders will incur fees, commissions, and taxes. High transaction costs can make an arbitrage trade unprofitable.
- Thirdly, retail traders lack access to advanced trading technology. Large firms use automated trading algorithms to spot and carry out arbitrage trades instantaneously. Retail traders relying upon manual trades will too often miss an opportunity.
- Fourth, price gaps close quite quickly. Many traders remain in search of arbitrage opportunities. When one appears, they move fast enough to make the price gap disappear almost instantly. Retail traders usually do not have the speed or tools to enter and exit trades before institutional and experienced traders.
- Finally, sudden changes in the market conditions can occur. Any unexpected news or events can influence prices. If traders are not able to execute both sides of a trade very quickly, they may be confronted with unexpected losses.
Conclusion
Overall, arbitrage trading is a strategic approach that benefits traders from discrepancies in prices. By choosing arbitrage trading, traders can benefit from several advantages, but they should also be mindful of the potential risks associated with this strategy.
However, to succeed in arbitrage trading, it is essential to develop market knowledge and the ability to execute trades quickly. Alongside this, to generate high-margin profits, individual investors should learn to utilise advanced technology and analytical tools and adapt quickly to the continuous changes in the market.
