What is Arbitrage Trading? What are Arbitrage Funds?
Arbitrage trading is the practice of buying shares of a company in one market and selling it in another market for a profit.
This is made possible because the price differences in different markets are not completely correlated and always a minute difference between them. For example: If TCS trades at Rs. 1800.00 on BSE, then there is a chance that it can trade at Rs. 1800.50 on NSE. If the trader buys it at 1800.00 from BSE and sells it at 1805.00 at NSE, then the profit made is Rs 5 per share (Rs 1805-Rs 1800). However, in India, this cannot be done on intraday orders.
In theory, Arbitrage is a risk-free trade, however, there are minor risks associated with it in practicality, like execution risk, mismatch, and liquidity risk. In most cases, arbitrage trades are executed using Algo-trading systems. Arbitrage trades on a large scale are done by Institutional Traders. This is because of the high capital requirement needed to make a significant profit.
Arbitrage Trading Opportunities in India
There are various types of arbitrages possible in the Indian market. We'll discuss them in detail in a later article.
The types of arbitrage are:
- Cash and Carry Arbitrage: They are performed in one single market. In Cash and Carry Arbitrage profit is made from the difference in price in the spot market(equity) and futures price. In Cash and Carry arbitrage, you BUY a certain number of shares equal to the lot size in the spot market and SHORT the futures of the same amount. The difference in price over a period of time is your profit. We shall discuss this in a separate article.
- Reverse Cash and Carry Arbitrage: This follows an opposite mechanism where you SHORT a certain number of shares equal to the lot size in the spot market and BUY futures of the same amount. The difference in price over a period of time is your profit.
- Currency Arbitrage: Currency Arbitrage arbitrage is when you take advantage of the price disparity of currency in two markets to book a profit. For Example, A bank in New York quotes the currency pair USA/INR 70.20, and a bank in India quotes the same pair 70.94. A trader who is aware of this price difference can perform arbitrage and book profits. There are multiple ways of performing a currency or forex arbitrage, but the essence of it remains the same.
- Inter-Exchange Arbitrage: In this form, you take advantage of the price difference of the same scrip in two different exchanges. Example: TCS is quoting 1202.00 in BSE and is quoting 1202.90. There are a total of Nine Exchanges recognised by SEBI in India. In India, inter-exchange arbitrage is not possible on intraday orders.
Arbitrage Funds are those Mutual Funds that use arbitrage trading as means to multiply their money. An arbitrage fund is suitable for those investors who want to take advantage of highly volatile markets but have a reduced risk burden. Volatility is what makes arbitrage profitable. Arbitrage funds are taxed the same as equity funds, on capital gains. They may have a high expense ratio and are suitable for investors having a short to medium-term horizon of 3 years to 5 years. In the medium to long term, Arbitrage funds are known to give returns between 7% to 8%. However, it is suggested that an investor does his own research before investing in these.
You can check out a number of arbitrage funds and their performance over here.