Arbitrage : Meaning and Definition

There are many types of players in capital markets. They use different strategies to make a profit. You can either buy or sell in a matter of hours following a broader market trend, or you can buy at a lower cost and keep it for the long-term. These strategies all aim to make a profit. These trades can be executed in one market but you may also make a profit by using the price difference of the same asset in other markets.

What's arbitrage?

Capital markets are efficient, according to mainstream economic theory. Capital markets' efficiency ensures that assets are priced equally in all markets. However, the reality may be slightly different. Sometimes, a price differential can be created between the same asset traded on different markets because of a variety factors such as different perceptions or different structures and functions. Arbitrage trading is when a trader exploits a differential.

What's arbitrage trading?

Arbitrage is the price difference of the same asset on different markets. Arbitrage trading is the profit from this differential. It is essential to understand what arbitrage means. The function of supply and demand determines the price of an asset. Stock exchanges have some inherent efficiencies that allow for minor monetary glitches to occur for a brief time. Traders are able to profit from these glitches by waiting.

Arbitrage traders use arbitrage traders to exploit the mismatch between demand and supply of security securities on different exchanges. Arbitrage traders will sell an asset in the higher-priced market while simultaneously purchasing the asset in a lower-priced market. Arbitrage trading may seem complicated, but it is actually a straightforward and risk-free trade. Automated systems are used by many traders to execute arbitrage trades. It automatically detects price discrepancies, executes the trade and corrects the market.

What does arbitrage mean in stock market trading?

Forex trading is a common place where arbitrage opportunities can arise, but arbitrage trading in stock markets is also not uncommon. Is it possible to ask what arbitrage trading is in the stock market? Arbitrage trading in stock market can only be done if stocks are listed on multiple exchanges that have different currencies. A company ABC can be listed on both the New York Stock Exchange and the BSE. ABC shares trade at $3 on NYSE while their price on BSE is Rs 148. Consider the dollar/INR exchange rate as Rs 50. This means that $1 equals Rs 50. The stock price on the NYSE will be Rs 150 in Indian rupees at the above exchange rate. Arbitrage trading is possible as the stock price on the NYSE is Rs 150 and the BSE at Rs 148. Arbitrage traders would purchase the stock on BSE and then sell it on the NYSE for Rs 2. This would give them a profit of Rs 2.

Limitations

Arbitrage trades can be considered risk-free moves but there are still risks. Arbitrage trading opportunities are not active for very long. Arbitrage trading can balance the risk of an arbitrage opportunity since increased demand could rectify the price discrepancy. Arbitrage trading involves the risk of price volatility. An abrupt rise in price for an asset on the market at a lower price could cause it to drop and result in losses.

Conclusion

Arbitrage trading is still relevant due to market inefficiencies. Arbitrage traders must ensure that transaction costs are low because arbitrage traders often have low price differentials. A high transaction cost will compensate for the arbitrage difference. Arbitrage trading opportunities are not predictable and must be capitalized on a short notice. Arbitrage trading is a risk-free and relatively easy activity if done correctly.