Arbitrage Trading in India – How Does it Work and Strategies

The Indian financial sphere is always changing. Stock prices rise and fall, currency value fluctuates, and futures and options exhibit thrilling price moves. In this dynamic finance ecosystem, there lies a valuable opportunity for savvy traders known as arbitrage.

Today’s blog covers the basics of arbitrage trading, different arbitrage strategies, key risks involved, and important points to consider before indulging in arbitrage trading.

What is Arbitrage Trading?

Arbitrage Trading is when you take advantage of price differences for the same asset in different markets. You can make a profit by buying an asset at a low price in one market and selling it at a higher price in another market.

Features of Arbitrage Trading

Features of arbitrage trading are listed below:

1. Price Discrepancies: The core principle of arbitrage trading is a difference in the stock price in different markets, which creates an arbitrage opportunity.
2. Simultaneous Transactions: Arbitrage trading is all about timing. If you buy an asset at a low price, you immediately need to sell it for a higher price. However, in reality, executions take some time to complete.
3. Regulatory Compliance: Arbitrage trading must follow regulations and market rules set by financial authorities and exchanges, including position limits and margin requirements.

Arbitrage Strategies

Arbitrage trading can be of various types. The different types are mentioned below:

Cash-Futures Arbitrage

This strategy takes advantage of the price difference between a stock’s current market price (spot price) in the cash market and its futures price.

For example, Reliance Industries stock is trading at INR 2,000 in the cash market. The nearest expiry of a Reliance futures contract is priced at INR 2,020. The futures contract is trading at a premium of INR 20. An arbitrageur will buy Reliance shares at INR 2,000 in the cash market and simultaneously sell the futures contract at INR 2,020 of equivalent quantity. Assuming the stock price stays constant at INR 2000 on the expiry day, the futures price will align with the stock price. The trader will close the futures position by buying back the futures contract and earning INR 20.

Merger Arbitrage

When a company plans a merger or acquisition, the target company’s stock price usually trades below the proposed acquisition price because of the uncertainty of the deal being completed. This creates an arbitrage opportunity.

For example, XYZ company announces that it will acquire ABC company for INR 1,000 per share. ABC’s stock price might initially trade at INR 900 per share because of multiple reasons. An arbitrageur will buy shares of ABC at INR 900. He will hold the shares until the merger is finalized, and once completed, he will sell them at the acquisition price of INR 1,000, hence pocketing the difference of INR 100 per share.

Dividend Arbitrage

This strategy involves buying a stock before its ex-dividend date (the date after which new buyers are not entitled to the upcoming dividend) and buying deep ITM put options of an equivalent quantity. The trader receives the dividend payment and any increase in the price and then exercises the put option to sell the stock at the strike price.

For example, Infosys declares a dividend of INR 5 per share with an ex-dividend date of 15^th July. The stock price was INR 1,300 on 9^th July. An arbitrageur will buy Infosys shares before 15^th July and also buy puts of equivalent quantity with a strike price of 1350. The trader receives INR 5 as a dividend and any price appreciation and will sell the shares after the ex-dividend date by exercising the put option. 

Cross-Exchange Arbitrage

This strategy takes advantage of price differences between related assets on different exchanges.

For example, an Indian company like Tata Motors has its shares listed on the NSE and also trades on NYSE. A temporary price difference between these two will create an arbitrage opportunity. The trader would buy the cheaper one and sell at a higher price on the other exchange.  

Arbitrage Trading Examples

Imagine if company ABC shares are traded on both the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). In India, arbitrage trading involving NSE and BSE can only be carried out if the shares are already held in the demat account. 

If the price of ABC shares on the BSE is INR 200 and on the NSE is INR 210, an arbitrage opportunity exists. A trader can sell the shares in the demat account on NSE at INR 210 and buy them back instantly on BSE at INR 200. This yields a profit of INR 10 per share.

Key Points to Consider When Doing Arbitrage Trading

Traders must understand the following points before doing arbitrage trading:

1. Arbitrage opportunities do not last long. Executing both buy and sell orders at the same time is very important. Delays in processing orders or slow execution can wipe out the profits.
2. SEBI prohibits taking advantage of price differences between Indian stock exchanges for the same stock on the same day. Rules prevent simple cross-exchange arbitrage.
3. In theory, arbitrage is a risk-free way to make money. However, execution costs and market movements can lead to unforeseen expenses.
4. Even though the concept is simple and successful, it involves a deep understanding of the markets and may not be a good fit for all traders.
5. If you are new to arbitrage, it is wise to start with small trades to gain experience and manage risks effectively.

Risks Involved in Arbitrage Trading

Although arbitrage trading is often considered a low-risk strategy, there are some risks involved that we need to look out for in the Indian market.

1. Indian markets are becoming more efficient, and price differences do not last long. Traders must execute their trades promptly to capitalize on opportunities before the market corrects itself.
2. Brokers charge fees, and there are taxes to consider. These can erode your gains because arbitrage opportunities have small profit margins.
3. It might become difficult to buy or sell the exact quantity of assets you need at the desired price, especially for stocks or contracts with low liquidity.
4. Technical glitches and unexpected regulatory changes can also disrupt the strategies.

Conclusion

To sum it up, arbitrage trading does not guarantee profits. It needs constant attention, sharp market observation, and flexibility to adapt to changing rules. A trader needs to understand different types of arbitrage strategies and select the one which best suits the individual. 

Arbitrage trading can be a valuable skill for achieving success, but traders must also be aware of the risks involved and should always consult a financial advisor before trading.

Frequently Asked Questions (FAQs)