Mispricing Opportunities – Diving into the Concept of Arbitrage

In the world of investments, there are several strategies one could use. But while talking about markets, we usually talk about either long-term investing or intraday trading, often leaving out another category – that of Arbitrage. The name sounds like a fancy French dessert! Doesn’t it?

Well, if you are too confused about arbitrage trading, you are not alone. A majority of retail investors are unaware of this strategy. Here we will dive into the basics and tactics of arbitrage.

What is Arbitrage?

Simply put, arbitrage is a trading practice wherein one buys an asset from one market and sells it in another market to make a quick buck. While price differences are typically small and short-lived, the returns can be impressive when volumes are large.

To understand this better, take a closer look around you. Arbitrage opportunities exist even at local levels. For instance, if grapes are sold at Rs 40 per kg in Dadar market in Mumbai and at Rs 50 kg in Andheri, the vendor can take advantage of the pricing differentials. He can buy from Dadar market and supply it in Andheri. Voila! It’s straightaway arbitrage profit.

Hunting Mispricing Opportunities

In the stock market, too, there is an opportunity for arbitrage in a stock. As a straightforward example of arbitrage, consider the following. The stock of company ‘Smart’ is trading at Rs 110 on the BSE while, at the same moment, it is trading for Rs 112 on the NSE. A trader can buy the stock of ‘Smart Company’ on the BSE and immediately sell the same on the NSE, earning a profit of Rs 2 per share.

With too many arbitrageurs, this anomaly soon disappears as everyone buys it at the lower price and tries to sell it at a higher rate, thereby pressurizing the markets to correct. This section of investors therefore, keeps a check on the inefficiencies in pricing across the markets.

Hence, arbitrage can be used whenever any stock, commodity, or currency may be purchased in one market at a given price and simultaneously sold in another market at a higher price.

Types of Arbitrage

The example above was a Pure Arbitrage. Apart from that there are other arbitrage opportunities that people hunt for. Merger arbitrage is one of them. It is based on the likelihood of an event in the future, and involves investors weighing such a possibility. In its most basic form, merger arbitrage involves an investor purchasing shares of the target company at its discounted price, then profiting once the deal goes through. Similarly, there convertible arbitrage, arbitrage in futures market and so on.

So Simple! But Why Isn’t It Widely Used?

In real life, arbitrage opportunities exist only for brief periods. Most of the arbitrage trading has been taken over by algorithm-based trading in matured markets. With advances in technology, it has becomes difficult to profit from pricing gaps in the market. Hence, arbitrage is commonly leveraged by hedge funds and other large investors.

Note that, not every investor or trader makes money. Also, the market does not always provide arbitrage opportunities. But yes, the markets do give sufficient returns for long-term investors who do their homework on the stocks or assets they invest in.

Quoting Mark Twain here, "There are two times when one should not speculate: once when he can afford to and once when he cannot."

References: Investopedia

Economic Times

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