Dec
22
2015

Arbitrage Trading

Arbitrage trading is something seen as very exciting and risk free opportunity by day traders. It can be defined as a risk free strategy (atleast theoretically) of simultaneous buying and selling of a same/similar assets in different markets. Traders doing arbitrage trades are referred as arbitrageurs.

Arbitrage trading is based on market inefficiencies. In real world markets are assumed to represent the true value of a stock and when there are discrepancies in the market price and the true worth of a stock, there exists opportunities for arbitrage trade; as arbitrageurs expect this difference to be leveled-out soon. Arbitrage opportunity is also present when a same asset has different price across different markets. As according to ‘Law of One Price’ same asset should have same price across various markets.

The exact trading strategy could be understood from the following mock scenario.

Consider a stock having with the following price in two different markets at various points in time as given in the table below.

 

Time NSE BSE Difference in price Trade Strategy
11:00:10 82.02 82.02 0  
11:00:12 82.12 82.12 0  
11:00:14 82.18 82.15 0.03  
11:00:16 82.26 82.18 0.08 Buy @82.18 (BSE) sell @82.26 (NSE)
11:00:18 82.40 82.20 0.20  
11:00:20 82.55 82.22 0.33  
11:00:22 82.60 82.34 0.26  
11:00:24 82.62 82.40 0.22  
11:00:26 82.65 82.48 0.17  
11:00:28 82.68 82.57 0.11  
11:00:30 82.71 82.71 0 Sell @82.71 (BSE) buy @82.71 (NSE)
Profit/loss       +0.53 (BSE) and -0.45 (NSE)
Net profit       +0.08 per stock

 

As evident from the above table such arbitrage opportunities are extremely short lived and need very accurate observance and quick decision to get into the trade. As soon as an arbitrageur spots the variation in price between two markets he may take positions by selling the one at higher price and buying the one at lower price. Finally by taking opposite positions once the price comes at nearly same price or until both trades give you net profit.

However to earn profit from such trades, number of positions to be taken is generally taken as huge. As the profit of the above mock trade for a single stock is just 8 paisa but when trade has been done for 100 stocks it would be Rs. 8. Day traders can generally spot several opportunities during a day and increase such risk free profits.

Arbitrage is conceptually a risk free strategy as market price is never expected to have differences across markets and if such inefficiencies exists they are expected to disappear within moments.

However with the modern trading technologies used by stock exchanges such opportunities are very rare to be spotted and manually spotting them becomes a challenge. But by using High Frequency Trading (trading by algorithms) these could be easily caught.

There are various types of arbitrage trading strategies depending upon the type of trade/asset class we trade. Some of the arbitrage strategies are:

  • Statistical arbitrage
  • Market arbitrage
  • Risk arbitrage
  • Index arbitrage
  • Speculative arbitrage
  • Merger arbitrage

Eventhough arbitrage trades are conceptually risk free still they bear risk when the market price do not converge for a longer duration of time, prices move in unexpected direction or both the trades taken offset each other resulting in no profit but still would cost brokerage.

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