Arbitrage is basically buying a security in one market and simultaneously selling it in another market at a higher price, profiting from the temporary difference in prices. This is considered riskless profit for the investor/trader.
In the context of the stock market, traders often try to exploit arbitrage opportunities. For example, a trader may buy a stock on a foreign exchange where the price has not yet adjusted for the constantly fluctuating exchange rate. The price of the stock on the foreign exchange is therefore undervalued compared to the price on the local exchange, and the trader can make a profit from this difference.
Many day traders look for arbitrage opportunities following mergers or acquisitions. For example, a to-be-acquired company may trade below the acquisition price due to the risk of the transaction falling through.
Here is an example of an arbitrage opportunity.
In this case, you buy in one ex change and sell in another. For example a RIL is at Rs 1,035 on BSE and at Rs 1,038 on NSE, you can capture the Rs 3 difference. However, cross selling across ex changes is not allowed in Indian markets, so you have to reverse the position before end of day as trade needs to be squared off on the same exchange.
Transaction costs can turn a possible arbitrage situation into one that has no benefit to the investor. If the trading fees per share or in total costs more than the total arbitrage return, the arbitrage opportunity would be erased. In the above example, you make Rs 3 (less brokerage) if the RIL prices converge before market closes on that day. However, you lose if the gap widens further. But if you have delivery position in a stock, you can execute risk-free arbitrage (i.e. you can give delivery in one exchange and take delivery from another exchange).
Mostly institutional investors or mutual funds or traders asso ciated with stock brokers take advantage of arbitrage opportunities.They use software that helps them detect and execute such trades fast. It may be difficult for retail in vestors to earn big returns using arbitrage. Arbitrage trading has to be very quick and a retail investor, in manual mode, may miss the opportunity in a blink.
Arbitrage is typically associated with trading in financial instruments like bonds, stocks, derivatives, commodities and currencies. There are different types of arbitrage including Merger arbitrage, Convertible bond arbitrage, Regulatory arbitrage, Depository receipts, Municipal bond arbitrage, and Telecom arbitrage. There are some preconditions that are essential for a profitable arbitrageto take place. If any one of the following point is true for a given condition then it is assumed that a profitable arbitrage is possible.