Every day, thousands of investors and traders participate in capital markets. All participants share the primary goal of making a profit. Trading on the stock market is possible using a variety strategies and techniques. A trading strategy is only applicable if the asset's price moves in a favorable direction. Arbitrage is a simple but uncommon way to gain capital markets gains.
It is important to understand what arbitrage is before you can understand how it works. Arbitrage is the simultaneous selling and buying of the same asset in two markets in order to profit from the differences in prices in each market. Arbitrage can occur in any asset that is traded on different markets in a standard form. However, it is more prevalent in stock and currency markets. Arbitrage opportunities can be short-lived and last only seconds or minutes. Arbitrage opportunities are possible despite popular economic beliefs. The market demand and supply determine the price of an asset. Arbitrage trading can be used when there is a discrepancy between the supply and demand for an asset in different markets.
Arbitrage trading depends on the ability of the trader or broker to capitalize on price differentials in different markets for the same asset. Arbitrage opportunities are extremely rare so most traders use computers for arbitrage trades. Let's look at an example to show how arbitrage works on the stock exchange. Let's say that XYZ stock is listed on both the National Stock Exchange (NSX) and the New York Stock Exchange. The price of XYZ on the NYSE is quoted in US Dollar, while it is quoted on the NSE in Indian Rupees. The share price for XYZ is $4 per share on the NYSE. The NSE's share price is Rs 238. If the USD/INR exchange rates are Rs 60, then the share price for XYZ in INR on the NYSE will be Rs 240. The same stock is quoted at Rs 238 and Rs 240 on NSE, respectively, if USD is converted into INR.
A trader can buy shares of XYZ for Rs 238 on the NSE, and then sell them at Rs 240 on NYSE. This will allow him to make a profit of Rs 2. Arbitrage trades can be risky and traders must consider these risks. A favorable exchange rate is what causes the price differential, which is always changing. Losses can result from any significant change in the exchange rate during the execution of a trade. Transaction charges are another important consideration. The transaction costs that exceed Rs 2 per share will negate the price differential.
Companies that are not listed on Indian stock exchanges and foreign exchanges are rare. India has two major stock exchanges: the NSE and BSE. Most companies are listed on both of these exchanges, which creates an opportunity for arbitrage. Arbitrage trading is not possible, even if the NSE or BSE prices are different. Traders cannot buy and sell the exact same stock on multiple exchanges in the same day. If you purchase shares of XYZ today on NSE, it can't be sold on the BSE the next day. How does arbitrage work then? You can sell shares you already own in the DP and then buy the same amount on another exchange. If you have shares of XYZ already, you can either sell them on BSE or buy them from the NSE. It is prohibited to trade the stock on different exchanges if you already own it.
Arbitrage trading is generally done using automated systems, as the price differential won't last for long. Although it is possible to spot arbitrage opportunities, manual profiting is difficult.