Arbitrage Explained
With the recent frenzy among investors and traders to start investing their capital in the stock markets, some traders look for low risk and high reward strategies. Although their demand may be considered irrational, there’s one strategy that affluent investors use to earn profits by using a shallow risk strategy. This strategy is known as Arbitrage, which exploits the inefficiency of stock markets by capitalizing on the discrepancy between trading prices for the same asset across different markets. They can capitalize on the difference by buying securities at a lower price and selling them at a higher price on a separate exchange.
However, this strategy is used majorly by high net worth individuals because usually, the differences between the buying and selling prices are minute. The trader also has to overcome the transactional and financial costs incurred to make a net profit. If the trading costs are prohibitively higher than the profit per share, it may turn into a net neutral trade. For example, if you’re making 20 rupees profit per share, but you find out that the trading cost comes out to be 19 rupees, then it would no longer remain a favourable trade.
Let’s assume that the stock of company X trades in the New York stock exchange at 40$ and trades in the London stock exchange at 39.4$ at the same time. Now the individual decides to sell the stock in NYSE at 40$ and buys the stock at 39.4$ on London Stock Exchange. The difference of 0.6$ per share becomes your net profit, and this amount is multiplied by the total shares traded. Hence, the more shares you trade higher will be your profit in that trade.
Consequently, you aren’t the only one who saw the price difference at the two exchanges. Hence, the demand will increase where the stock price is lower, and the supply will increase where the stock price is higher. As time passes, the prices normalize, and the difference ultimately becomes your profit.
As most investors don’t have the capital essential to carry out arbitrage trades, they may invest in Arbitrage Funds. Similar to other mutual funds, they can pay in Lump Sum or start a SIP to invest in these funds. Arbitrage Funds houses invest around 65-70% of the total capital in equities, 10% as liquid capital, and the rest in the debt market acting like hybrid mutual funds. Arbitrage fund returns depend on the market’s volatility and may range from 9-10% in high volatile phases and 4-5% in low volatile markets. If you calculate a rough estimate by looking at historical data, they can generate around a 6% rate of return annually.
Consequently, you may ask why I should invest in an Arbitrage fund. These funds are the sole funds that generate greater returns when the markets go through volatile phases. When the markets are volatile, there’s a higher chance that the difference between the buying and selling price is higher, leading to a broader spread and higher gains.
There are three types of Arbitrage strategies – Interexchange arbitrage, Cash and Carry Arbitrage and Reverse Cash Arbitrage. Interexchange arbitrage is practised when there’s a difference between the trading prices at NSE & BSE. The trader capitalizes on these differences and settles them to gain the respective profit. Cash and carry arbitrage capitalizes on the difference between the spot price and the futures price of a stock. When a stock is in a bull trend, there’s a very high chance that the stock is bound to go even higher in the future. Hence, the futures contracts trade at a premium to the spot price. However, these contracts last only for a month, which means that the price differences need to be settled at the end of the month. To carry out this trade, you buy the stock in cash and sell its future contract. The difference is the profit you earn from the trade. The third approach refers to Reverse Cash arbitrage. When a script receives fundamental bad news and starts plummeting, the futures contract starts trading at a discount to the stock price. Here you sell the stocks you already have in delivery and simultaneously buy the futures contract.
Although there are more than 40 different ways of carrying out arbitrage trades, I have tried to present the most convenient and valuable strategies for you to carry out. Arbitrage trading represents a low-risk, high return strategy that is bound to make you consistent profits.
