How does arbitrage trading work?

Although it might seem complex, the principle behind arbitrage trading is quite simple – taking advantage of price disparities. This type of trading, when done correctly, is largely risk-free and holds the potential for massive gains.

In today’s article, let’s explore the meaning of arbitrage and how arbitrage trading works!

What is arbitrage trading?

In stock markets around the world, when thousands of companies are traded on multiple exchanges at the same time, there are bound to be some inefficiencies. Arbitrage exploits these inefficiencies to make money.

It involves identifying opportunities to buy and sell similar assets in different markets to take advantage of tiny price differences at scale.

Arbitrage in the stock market is used whenever any stock or commodity can be purchased at a given price and sold in another market at a higher price. Since there is no speculation involved, a successful arbitrage trade is considered risk-free.

An arbitrage example

Let’s say Company X, that is listed on both the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), is currently trading at ₹100 at the NSE. Now, due to a temporary discrepancy, Company X is being traded at ₹103 at the BSE. This situation is usually caused due to order imbalances.

To make a profit, an arbitrage trader could simultaneously buy the arbitrage stock on the NSE at ₹100 and sell it on the BSE at ₹103, pocketing a risk-free profit of ₹3 per share, provided the trader acts quickly.

This type of arbitrage is known as spatial arbitrage, as it exploits the price difference between the two exchanges. Factors like transaction costs, market liquidity, and the time taken to execute these trades must also be considered while calculating profits.

The arbitrage process

1. Choose your assets – You must choose stocks, currencies, or commodities that are highly correlated in some way. That way, you could try to understand how discrepancies occur and how to spot them. 
2. Analyse your market and track prices – Keep a check on different markets where your assets are traded. Compare prices on different exchanges, across countries, or even over different time periods.
3. Calculating your spread and costs – The spread is the price difference between the same or similar assets in different markets. This has to be large enough to cover your costs and make a worthwhile profit.
4. Risk assessment – Evaluating your risks before entering the trade is important. Realistically analyse your execution speed, liquidity, market volatility, and potential external events that could have an impact on your calculations.
5. Execution strategy and automation – Depending on the type of trade, you could choose different execution methods. There are plenty to choose from. Since many arbitrage opportunities require split-second decision-making, sophisticated trading algorithms and automation tools are often used to minimise human error.
6. Monitoring and adaptation – Markets are hardly static. A successful arbitrage trader needs to adjust strategies often and learn from their mistakes to ensure that they get better at understanding the market over time.

Types of arbitrage trading

• Spatial arbitrage – When traders buy assets from different geographic locations, it is called spatial arbitrage. Due to different statutory rules and regulations, some countries could potentially offer better bets on the same asset. 
• Cross-exchange arbitrage – Unlike spatial arbitrage, this type happens between exchanges within the same physical jurisdiction. Traders make a profit from the price differences across exchanges by buying low and selling high.
• Triangular arbitrage – As the name suggests, triangular arbitrage involves trading three assets. In this type, traders shift their capital from one asset to another very quickly with the help of special algorithms and equipment. As long as they maintain low transaction costs, traders can net a decent profit with such manoeuvres.
• Statistical arbitrage – This approach involves identifying patterns or relationships between different assets and exploiting those patterns for profit at scale. Statistical arbitrage often involves pairs trading, where a trader simultaneously goes long on one asset and short on another that is historically correlated. This is also a popular risk management tactic.
• Risk-free rate arbitrage – Also called yield farming, this type of arbitrage takes advantage of differences in interest rates. A trader involved in this segment might borrow funds at a lower interest rate and invest in a higher-yielding asset, effectively profiting from the difference in rates. 

Conclusion

Even though arbitrage might sound like an easy way to make money without significant risk, you must remember that there’s no such thing as a free lunch. There are risks involved in everything, even when it might seem to be the opposite.

Arbitrage traders must simultaneously plan and execute trades, stay on the edge, and constantly monitor asset pairs, markets, and prices to identify trades. So, we encourage you to do your own research before you start arbitrage trading and keep these risks in mind. Until then, happy learning!

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