How to Use Arbitrage in Trading
September 14, 2022
Arbitrage is a trading strategy involving the simultaneous buying and selling of assets on different exchanges to earn profits from the price differential. Traders interested in risk-free trade can exploit inefficiencies in the market to book short term profits. Let's understand this strategy better.
How Does Arbitrage Trading Work?
Arbitrage depends on traders' ability to capitalise on differences in asset listed prices across different stock exchanges. However, the difference in prices is short-lived, i.e. for a few minutes or seconds. Arbitragers (traders) use sophisticated software programs to identify arbitrage trading opportunities and carry out their trade.
Let's understand with an example.
Joshi is a trader. He is looking for arbitrage strategies and opportunities to earn quick returns. A stock ABC trades on NYSE, and the same stock also trades on BSE. The price of a stock on NYSE is $5, whereas the same stock is trading at BSE at Rs. 346. Now, let's say that the exchange rate of US/INR is $1 = Rs. 70. Now going with this calculation, the share price of ABC stock on NYSE is Rs. 350 if USD converted into Indian Rupees. At the same time, ABC is quoted at Rs. 346 on BSE.
Joshi, who has access to both markets, can buy the stock on BSE at Rs. 346 and sell the same stock on NYSE at Rs. 350, thereby making a profit of Rs. 4 on every share transacted. The foreign exchange rate and underlying demand and supply conditions prevailing in both markets create favorable opportunities to carry out arbitrage trading.
Essential Conditions for Arbitrage
Here are two essential conditions for undertaking arbitrage trading in India:
• Asset price mismatch
The same asset should trade at a different price in different markets for arbitrage to happen.
• Simultaneous transaction
The trader should carry out buying and selling of assets in different markets simultaneously. A window of arbitrage is open for a very small duration, so the earlier one carries out a transaction, the higher the chances of generating profits.
How Does Arbitrage Trading Work in India?
There is a dearth of companies in India that are listed on the Indian stock exchange as well as foreign stock exchanges. So, the opportunity for arbitrage is very low in the case of foreign exchanges. India has two major exchanges - NSE and BSE and a majority of listed companies are traded on these two stock exchanges. This creates chances of arbitrage for traders interested in Indian stock exchanges.
However, there is a catch to the story. Indian capital market regulator SEBI does not allow traders to buy and sell the same stock in different exchanges on the same day. Therefore, one cannot indulge in arbitrage trade easily. In such a scenario, a trader can arbitrage by selling shares of stock already present in his Demat account on one exchange. The trader can then buy the same amount from a different exchange.
For example, shares of ABC can be sold on BSE, and the same quantity of ABC shares can be bought on NSE. This practice is not considered an intraday trade.
Arbitrage is a great opportunity for risk-averse traders to book profits on stock exchanges. However, transaction costs and the small window of opportunity available to execute the trade are some challenges traders need to evaluate before opting for arbitrage.