by Arbitrage involves simultaneously buying and selling a security at two different prices in two different markets, with the aim of making a profit without the risk of prices fluctuating.
Arbitrage strategies arise simply because of the way the markets are built. There are inefficiencies in the market owing to lack of information and costs of transaction that ensure that an asset’s fair or true price is not always reflected. Arbitrage makes use of this inefficiency and ensures that a trader gains from a pricing difference.
Depending on the markets involved, there are different arbitrage strategies. There are strategies that relate to the options market and there are specific arbitrage strategies that refer to the futures market. There are also strategies for the forex markets and even retail segments.
Arbitrage in Finance
Arbitrage is the process of simultaneously buying and selling a financial instrument on different markets, in order to make a profit from an imbalance in price.
An arbitrageur would look for differences in price of the same financial instruments in different markets, buy the instrument on the market with the lower price, and simultaneously sell it on the other market which bids a higher price for the traded instrument.
Since arbitrage is a completely risk-free investment strategy, any imbalances in price are usually short-lived as they are quickly discovered by powerful computers and trading algorithms.
Types of Arbitrage
While arbitrage usually refers to trading opportunities in financial markets, there are also other types of arbitrage opportunities covering other tradeable markets. Those include risk arbitrage, retail arbitrage, convertible arbitrage, negative arbitrage and statistical arbitrage.
Risk arbitrage: This type of arbitrage is also called merger arbitrage, as it involves the buying of stocks in the process of a merger & acquisition. Risk arbitrage is a popular strategy among hedge funds, which buy the target’s stocks and short-sell the stocks of the acquirer.
Retail arbitrage: Just like on financial markets, arbitrage can also be performed with usual retail products from your favourite supermarket. Take a look at eBay for example, and you’ll find hundreds of products bought in China and sold online at a higher price on a different market.
Convertible arbitrage: Another popular arbitrage strategy, convertible arbitrage involves buying a convertible security and short-selling its underlying stock.
Negative arbitrage: Negative arbitrage refers to the opportunity lost when the interest rate that a borrower pays on its debt (a bond issuer, for example) is higher than the interest rate at which those funds are invested.
Statistical arbitrage: Also known as stat arb, is an arbitrage technique that involves complex statistical models to find trading opportunities among financial instruments with different market prices. Those models are usually based on mean-reverting strategies and require significant computational power.
Arbitrage trading tips
- If you are interested in exchange to exchange trading, it would involve buying in one exchange and selling in another. You can take it up if you already have stocks in your demat account. You would need to remember that the price difference of a few rupees in the two exchanges is not always an opportunity for arbitrage. You will have to look at the bid price and offer price in the exchanges, and track which one is higher. The price that people are offering shares for is called the offer price, which the bid is the price at which they are willing to buy.
- In the share market, there are transaction costs which may often be high and neutralise any sort of gains made by an arbitrage, so it is important to keep an eye on these costs.
- If you are looking at arbitrage where futures are involved, you would have to look at the price difference of a stock or commodity between the cash or spot market and the futures contract, as already mentioned. In the time of increased volatility in the market, prices in the spot market can widely vary from the future price, and this difference is called basis. The greater the basis, the greater the opportunity for trading.
- Traders tend to keep an eye on cost of carry or CoC, which is the cost they incur for holding a specific position in the market till the expiration of the futures contract. In the commodities market, the CoC is the cost of holding an seet in its physical form. The CoC is negative when the futures are trading at a discount to the price of the asset underlying in the cash market. This happens when there is a reverse cash and carry arbitrage trading strategy at play.
- You can employ buyback arbitrage when a company announces buyback of its shares, and price differences may occur between the trade price and the price of buyback.
- When a company announces any merger, there could be an arbitrage opportunity because of the price difference in the cash and the derivatives markets.
