The word arbitrage is now a part of the stock market. In economics, by definition from the Oxford Dictionary arbitrage meaning is ‘the simultaneous buying and selling of securities, currency or commodities in different markets or in derivative forms in order to take advantage of differing prices of the same assets‘. The word arbitrage trading comes from it. Originally it comes from the Latin word arbitrary. But the current form of meaning evolves from the late 19th century.
In stock market terms arbitrage means you buy a security and sell it somewhere else. Hence your investment becomes almost risk-free. At times, due to pricing imbalance, the stock market gives us such opportunities. Some traders wait for such opportunities and grab them when they appear. In this article, I’ll try to show you how we can get such opportunities. There are investors who try to profit from such market inefficiencies. The stock market calls them arbitrageurs. These arbitrageurs are by trading nature, actually opposite to speculators. They invest where the risk is minimum and earn profit from market inefficiencies. This is one kind of arbitrage trading. The arbitrage meaning stands for risk-free investment here.
What is Arbitrage Trading?
The stock market needs such arbitrageurs to iron out the price differences. These experienced investors sit on the sidelines and wait for arbitrage opportunities to appear. Arbitrageurs search for opportunities in all assets at different exchanges. Arbitrageurs buy an asset that is lower priced and sells the same in a different exchange. Thus the investment becomes almost risk-free. These investors are not speculators. Rather they act in a completely opposite manner. Arbitrage opportunities exist in NSE, BSE, FOREX, Commodity, and across all other multi-segment platforms. The derivatives and F&O segments also provide very good arbitrage trading opportunities. In the later part of this article, we will find how arbitrage opportunities exist in different market segments.
An arbitrage fund is a different type of mutual fund. It invests in volatile market conditions by taking advantage of the price discrepancies of various assets. Therefore investors like investing in them for being almost risk-free investments.
Arbitrage trading mostly depends on this pricing theory. The theory depends on the multi-factor asset pricing model. There is a linear relationship between the expected return from an asset and the systematic risk of the market. If an asset is mispriced, an arbitrage opportunity is there.
The Asset Pricing Theory (APT) helps us to find arbitrage opportunities in the market.
The arbitrage meaning is there must be a price difference of equivalent assets in different but related markets. When such an opportunity exists, you buy the lower-priced asset in one market and short-sell the higher-priced equivalent asset in another market. When the price difference eases out, you profit.
Hedging is trading in more than one concurrent asset to minimize risk. But in arbitrage, we take advantage of price imbalance in the market.
It is an example of arbitrage arising due to differences in opinions of different bookmakers. When such an opportunity occurs, one bet with one company and bets the opposite with another company for the same event.
Arbitrage is an American crime drama film released in 2012 in the US. The movie was directed by Nicholas Jarecki and starring Richard Gere, Susan Sarandon, Tim Roth, Brit Marling, Laetitia Casta, and Nate Parker.
Arbitrage Pricing Model (ATP) for Arbitrage Trading
As we have already discussed in the FAQ section very briefly, it is an asset pricing model. But contrary to Capital Asset Pricing Model (CAPM) where the market is considered to be very efficient, the ATP accepts that pricing inefficiency exists in the market. This theory was discovered by Stephen Ross in 1976.
Using the above formula we calculate the amount of existing arbitrage and act accordingly. if the price difference is high, arbitrageurs or arbitrage fund managers jump for the opportunities. But unless the price difference is sizeable as per the investor’s opinion, the investor doesn’t come forward and take the call. Therefore, when the market price is far more than the fair value, we assume that there is an arbitrage opportunity. Many factors contribute to asset pricing as per ATP. Let’s have a look.
The picture above explains how the ATP model works. It is an example of how this model can be used in finding the asset price and the arbitrage opportunities.
The Meaning of Arbitrage Funds
there are many mutual funds that are active in this space. These fund managers wait for the right opportunities to appear for arbitrage trading. Once they find such pockets and they invest. They keep investing until the price differences wear out. Then they come out of their positions and wait for the next upcoming opportunity.
In many of cases, the fund managers buy in the cash market and sell in the F&O market or sell the derivatives, to be precise. These funds mostly encash the price differences that exist in the cash market and the derivatives market. Here is a table that shows the best arbitrage funds in India.
In addition to all these funds, some arbitrage funds need special mention. They are the Tata arbitrage fund and Axis arbitrage fund. Kotak Securities has two different kinds of arbitrage funds, Kotak arbitrage fund and Kotak equity arbitrage fund.
A Few Important Points on Arbitrage Funds
Arbitrage Funds vs Liquid Funds
Though both of these funds are different the returns are very compatible. Because the difference in spot and futures markets is mostly similar the interest rates largely. Also, this difference exists for very short periods. Therefore, arbitrage funds give similar returns to that liquid funds. But, whenever the price discrepancies occur, arbitrage funds get an extra advantage and the return increases. But most of the time market is not very volatile. Resultingly, both these funds give similar returns.
Arbitrage Funds vs Hedge Funds
We have already discussed their differences. These funds also work in similar ways. Therefore hedge funds may give higher returns than arbitrage funds. Hedge funds indulge in more risk.
Are Arbitrage Funds Safe?
Arbitrage funds are a very safe investment vehicle. Similar to liquid funds they give low returns. The low-risk strategy makes them very safe.
Meaning and Explanation of Different Kinds of Arbitrage Trading
This is another kind of arbitrage opportunity that exists in the online world. E-commerce is very much the area. it is a kind of online arbitrage. The method is the same. You buy at a low price and sell that product at a higher price. Let me give you an example. There are many sellers online who are selling similar products at different prices. You pick one product from a seller at a very cheap price. And you sell the same product on an online platform to another buyer. Here you earn arbitrage from price differences. Tactical arbitrage is a specific software used by traders for sourcing products for Amazon. This software finds online arbitrage opportunities for you.
Arbitrage and Speculation
These are completely two different investing or trading techniques. Speculators depend on hunches and news in advance, insider information etc for trading or investment. The very least amount of calculation is necessary for such kinds of investments. On the other hand, arbitrageurs invest in a calculative manner. The calculation finds arbitrage opportunities. Speculators play high-risk games. Therefore they have a chance to win big. But arbitrageurs invest in the low-risk position. Therefore their returns are also low.
Arbitrage with Options
Using options as tools for arbitrage is not a very uncommon practice. Because options are often highly-priced due to volatility (iv) and other factors. Arbitrage opportunity occurs when the volatility is factored in. The weekly options expire every week. During expiry, only the intrinsic values remain. All premiums become zero. Hence all extrinsic values become zero too. Thus the arbitrage traders scalp the premium when they play with delta-neutral strategies. Though these are more hedging than arbitrage trading.
Arbitrage with Futures
When the premiums become very high, a trader can buy in the cash market and sell the same scrip in the futures market. This is a kind of risk-free investment if the iv remains under the controllable range.
Is Arbitrage Legal in India?
Yes, it is legal in India if you are taking stock deliveries. In fact, many markets encourage arbitrage trading because this trading irons out market mispricing.
Arbitrage Trading and the Law of One Price
The law of one price suggests that the price of an asset should be the same at all locations across the globe. The price will not differ on the basis of geographical location or trading platform. Take the example of Crude Oil or Gold. The law states that the price of an identical asset should be the same everywhere. The law of one price, by definition, also suggests that
- The market should be frictionless and
- There will be no transportation costs,
- No legal transaction cost,
- And no price manipulation cost,
- The currency exchange rates will be the same.
Thus the law of one price exists, arbitrage trading will eliminate all the price differences eventually. An arbitrageur will buy an asset at a lower price. And the trader will sell it at a higher price in a different market. Over time, the market equilibrium will iron out all price differences. Thereby the law of one asset will be in force. Hence we can say that the law of one price demands the existence of arbitrage opportunities. Subsequently, arbitrageurs help to maintain the law of one force.
Where Can We Find Arbitrage Trading Opportunities?
Arbitrageurs are always on the lookout for rising arbitrage. Different exchanges bring us such opportunities. Retail traders used to look for arbitrage opportunities. Earlier paid software provided such information. The MoneyControl website provides such a list now free of cost. The list gives you futures prices of near expiry, next expiry, and far expiry. The list also shows the arbitrage opportunities that exist between the spot price and the futures price. If the difference is high, you buy the spot and sell the future. At expiry, both the prices converge and give you the profit. You can do this arbitrage trading with any combination, Spot – Near-Expiry, Spot – Next Expiry, or Spot – Far Expiry.
Thus far we can conclude that this is a good investment vehicle. Arbitrage opportunities let you scalp profit with minimum risk. Therefore the return on investment (ROI) is low. But you can increase the ROI by doing arbitrage trading at every opportunity across all trading platforms and across all exchanges. You go fast in and come out fast at most arbitrage opportunities. This way you can increase your profit with ease.