Arbitrage
Arbitrage is the art of spotting opportunities others miss. It’s like finding a product sold at two different prices in neighbouring shops and quickly buying from the economical one to sell at the higher price. In the financial world, this is done across stock exchanges, commodities or even currencies. It’s a smart way to earn profit from price differences.
What is arbitrage?
Arbitrage trading is a process of buying the same commodity, security or any other asset at a lower price in one market and simultaneously selling it at a higher price in another market. The aim is to purchase an asset in one location at a cheaper price and at the same time sell the same asset in another location where the price is comparatively higher in order to make a profit from the price difference.
For example, imagine a stock trading for ₹500 on the National Stock Exchange (NSE) while it's priced at ₹505 on the Bombay Stock Exchange (BSE). An arbitrageur would purchase the stock on the NSE and sell it on the BSE, pocketing the ₹5 difference per share. This process is possible because markets aren’t always perfectly aligned, allowing traders to exploit temporary inefficiencies.
How does arbitration work: A step-by-step guide
Here’s how the process of arbitrage unfolds:
- The first step is to identify that the price for an asset, for instance, a stock, a commodity or a currency is different in two markets. Such differences may occur due to various reasons including imbalance of supply and demand or time differences in the setting of prices between different exchanges.
- An arbitrageur then purchases the asset in the market which has a lower price and sells it in the market which has a higher price, both operations must be performed at the same time. This is to ensure that one can have a chance to fix the price difference before the markets open and close this gap.
- The profit from an arbitrage trade is the difference between the buying and selling prices, minus transaction costs like brokerage fees. Because arbitrage exploits market inefficiencies, the goal is to make a risk-free profit.
- Most arbitrage is done using complex algorithms and high-speed trading systems. These technologies enable traders to spot price differences and execute trades in milliseconds. This makes it essential for arbitrageurs to act swiftly.
When would arbitrage be a possible strategy?
Arbitrage becomes a possibility when there are differences in the price of an asset in two or more markets. For instance, a stock may be cheaper in one exchange and expensive in another, and the traders can buy from the cheaper exchange and sell from the expensive exchange to make risk-free profits.
These gaps are a result of market imperfections or variations in the availability of the products in different regions. But with the technology and modernisation, these opportunities are shut as soon as they are discovered.
What are the benefits of arbitrage?
Low-risk profit:
In its purest form, arbitrage offers a relatively low-risk way of profiting. Because it involves buying and selling the same asset simultaneously, the price difference is essentially guaranteed, making it a near risk-free strategy.
Improves market efficiency:
Arbitrage helps markets remain efficient by closing price gaps between different markets or exchanges. By doing this, it prevents the same asset from being mispriced for long periods.
Boosts liquidity:
Arbitrageurs often trade large volumes of assets, which adds liquidity to the market. This increased liquidity benefits all market participants by reducing the cost of transactions and making it easier to buy or sell assets.
Better use of capital:
By identifying and exploiting mispriced assets, arbitrageurs contribute to the proper allocation of capital. When assets are priced accurately, investors can make better decisions on where to allocate their funds.
Different kinds of arbitrage strategies
Pure
This is the most basic and straightforward type of arbitrage. Traders buy an asset where it's cheaper and sell it where it's more expensive, locking in a risk-free profit.
Risk
This happens during mergers or acquisitions. Traders buy stocks of the company being acquired, betting that the price will go up. It’s riskier because if the deal falls through, they could lose money.
Statistical
Traders use advanced algorithms and statistical models to find price patterns that differ from what’s expected. They act fast to profit from these small deviations.
Convertible
This type involves trading both a company’s stock and its convertible bonds. Traders profit by taking advantage of the price difference between the two.
Triangular
This involves three currencies. Traders profit by exchanging one currency for another in a cycle, benefiting from slight price differences between them.
Cash-and-Carry
The goal is to profit from the price gap between the two markets. Traders buy an asset in the spot (cash) market and sell it in the futures market.
Although arbitrage is often seen as a low-risk, high-reward strategy, it should be approached with caution. Speed is crucial, as arbitrage opportunities are usually short-lived, making the right tools and technology essential. Additionally, consider costs like brokerage fees, which can impact profit margins. Ensure there is sufficient market liquidity to support your trades. Remember, arbitrage typically involves large sums of money and requires professional knowledge, so some level of risk is always involved.
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