What is an Arbitrage?
Created on 05 Feb 2021
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Did you know that you can earn money simply by selling stock from one stock exchange to another?
Well, yes, you can. There are many strategies through which a prudent investor can earn profits. Arbitrage is also one of them.
Arbitrage is a strategy where a trader earns money by selling the same stock on different exchanges, where there is a price difference.
The king of value investing, Warren Buffett, could understand the arbitrage concept when he was six! He purchased 6 bottles of Coca-Cola for 25 cents and sold each bottle at 5 cents, thereby earning a profit of 5 cents.
Most often, traders buy stock from foreign exchanges and sell identical stock in the local market.
So, let us dive into the topic and understand the crux behind arbitrage:
Understanding Arbitrage in Finance
Arbitrage is a method of simultaneously buying and selling securities from different platforms and exchanges to cash in on the price difference between them and earn profits from it. A trader will look for differences in prices of the same securities in different markets. They will buy the securities from the market, offering a lower price and will sell the securities in the market where the prices are high. In this process, the quantity of underlying securities which are bought and sold are the same.
The earning should be large enough to earn a profit after deducting the transaction cost; otherwise, it will not be a profitable transaction for the traders. Although arbitrage is a risk-free strategy for the traders, mostly the difference in price is for a brief period because the trading algorithm detects the difference, and it is corrected.
Traders who use this strategy of arbitrage are known as arbitrageurs.
Example of an Arbitrage Trade
Complex trading concepts are best explained by examples. So, let us understand the concept of arbitrage through examples.
Suppose a stock of company AB trades at Rs. 50 on the National Stock Exchange (NSE). At the same time, the same stock of company AB is trading at Rs. 50.80 at the Bombay Stock Exchange (BSE). Arbitrageur will now buy the stock from NSE and sell it at BSE and earn a profit of Rs. 0.80 per stock from this transaction.
Now an individual trader will not be the only one who would have spotted this difference. There are hedge funds and arbitrage software as well who will trade immediately as the difference and risk-free trading are known to them. This will push the price at NSE due to high demand for the lower-priced stock of company AB. Simultaneously, due to the large selling of stock of company AB, prices at BSE will come down.
Different currencies of different nations are also used for arbitrage strategy. Currencies are traded on the over-the-counter (OTC) currency around the globe, unlike the stock exchange where trading is done on a centralised exchange. Due to this reason, currencies are popular for earning a profit on exchange rate differences.
Necessary Conditions for Arbitrage Trading
When the conditions given below are met, an arbitrage can happen:
Price difference: This is the main reason behind arbitrage. A price difference can occur when:
- The same securities are trading at a different price in a different market.
- The commodity with the same value is traded at a different price.
- Traders are certain about the future price of a certain asset, but there is a price difference between the expected price and the current price.
Simultaneous trade execution: For capitalising the arbitrage opportunity, purchasing and trading should happen simultaneously to get profit from the price difference. The trade will be exposed to substantial risk if the transactions do not happen simultaneously.
Arbitrage in Retail Trading?
Well, most of you who are reading this article are retail investors. So, it becomes important to understand whether a retail investor can get involved in arbitrage. Well, theoretically, retail investors can take advantage of the risk-free strategy of arbitrage, but it is extremely hard.
There is a huge competition between the retail investors, which restricts the price difference of most of the items. Also, even a lot of brokers discourage arbitrage trading. Moreover, considering the excessive cost of transaction involved in arbitrage, it becomes impossible for small retail investors to take advantage of it.
However, due to such hurdles, many investors are now learning machine language and artificial intelligence through which they plan to get an edge in various capital market strategies like arbitrage.
Limitations of Arbitrage Trading
Although arbitrage strategy is known for its minimal risk, it still is prone to some shortcomings.
The foremost limitation is that arbitrage trading often faces a shortage of time. The price difference can rectify at any moment due to excessive trade.
An arbitrageur considers the risk of price volatility during the trade. A sudden rise in the lower-priced stock or sudden downfall in the higher-priced stock can lead to huge losses.
Key Takeaways of Arbitrage
- Arbitrage is done when a security is purchased in one market and simultaneously sold in another market, for a higher price.
- The price difference of the same asset between the two markets lets traders lock in profits.
- The price difference is temporary, i.e., for a short duration of time.
- Traders frequently attempt to exploit the arbitrage opportunity by buying a stock on a particular exchange where the share price hasn't yet been adjusted from the fluctuating Stock Exchange rate.
- Arbitrage trading is considered to be a relatively low-risk exercise.
It is important to note that arbitrage occurs due to the inefficiencies in the market.
If you want to do arbitrage, then always consider the transaction cost involved in it, as an exceptionally low difference in price, and higher transaction cost will lead to losses instead of profits. It is also important to remember that these kinds of trades last for a short time, so the transaction should happen instantly.
Arbitrage can happen anytime, and there is not any specific time to do it. So, the trader should always look for them because arbitrage can be a simple and risk-free trade if done in the right way.
Lastly, always consider the pros and cons of arbitrage trading and then get involved in the transactions.
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