All the definitions on arbitrage trading say that it is “Buying in one market, selling in the other and profiting from the price difference.” Well, at first I thought it would be buying a share from BSE and selling it in NSE, as all the examples say- buying saaris from Surat market, where you get them cheap and sell in Mumbai market, where it can be sold expensive.
However, trading like this is not allowed in the stock market ie. you cannot buy and sell the same stock among exchange (NSE to BSE) in real time. So you cannot arbitrage by buying on NSE and Selling on BSE without holding the stock in your demat account. In case you do that and at T+2, the stock have not come in your Demat account, there would be a short delivery and will be taken to auction which can have huge implications in terms of penalty. So then how do we do arbitrage in equity markets.
Types of arbitrage opportunities
The most common arbitrage available in Indian stock market is a cash-futures arbitrage. Here, is an example of arbitrage say ITC Ltd. is trading at Rs.328 and ITC’s near month Futures is trading at Rs.330, then the trader will buy the stock and sell the futures contract. Not to forget, there is a lot size associated with derivatives. So the number of shares needs to be equal to the one in lots in case of ITC lot size is 1000 share. At expiry you can expect the price of future and the cash market to be same, and any difference you have earned would be the profit. This is also called cash and carry arbitrage.
When its currency arbitrage, you can say it’s a futures-futures arbitrage between MCX-SX and NSE. When a price difference i.e. an arbitrage opportunity is found, futures contract of, for example, INR/USD are sold in NSE at high price and purchased in MCX-SX at a lower price.
Note that, arbitrage trading has to be very quick as the price changes every micro-second. And secondly, there is no place for small number of shares. The price difference is very less, so it is very difficult to earn real return by a retail investor using arbitrage as he also have to pay brokerage charges and other government charges. So arbitrage opportunity is mostly taken advantage off by institutional investor and some mutual funds who deal with arbitrage. If you are doing this using your normal full service broker, it would be very difficult to earn more than the brokerage charged by your broker.
Arbitrage can also happen in the commodity market (spot and future) and also between near month and far month contracts.
In case you are a small investor, before thinking of going into arbitrage trading, make sure that you understand the concepts properly. This is something which is really difficult to do with small trading capital.
Arbitrage trading software
If in manual mode, arbitrage opportunities may be found and lost within a blink. Putting the automatic mode on, there are software’s to detect opportunities and also to execute trades. These software applications can build strategies for a trader, work on the traders strategies, they are fast, very fast, at executing trades, and come along with a lot more features. By the way, all this arbitrage trading is a legal thing. There are just a few rules you need to follow to be in the game and not be penalized. Most of the arbitrage trades are done by these algo making the market more efficient for everyone.
There are a number of IT companies that provide software, naming a few, Dataman, Odin, etc. A lot of strategic planning and algorithm is involved in all the arbitrage trade that takes place. You can find more details about arbitrage trading software at http://www.ftindia.com/solutions/brokerageSolutions/optsolutions.htm.
For all the investors in general, who cannot do this arbitrator act, but would like their money do be in the play, there are a lot of arbitrage funds out there. You just have to invest the money as you do in any other mutual fund and the fund manager will be the arbitrator for you.
From March 2015 to June 2015, AUM under arbitrage fund grew 92% and in equity MFs grew just by 8.8%. The minimum investment here is Rs.5000, just like any other MF. Arbitrage funds discover price differences between different market and exchanges. These funds have tax benefits as well (the dividends on equity and long-term capital gain is not taxable). A small percentage of the fund is also invested in debt. All fund houses have different investment strategies. And the investor must make his good choice.
The cash exposure to equity or debt or just holding on cash is important here. The returns depend on the fund manager’s strategies and how and when he uses the funds. See how the fund performed when markets were in uptrend and in down. A few years of historical returns also help to decide which fund to invest in.
Here are three of many arbitrage funds showing their returns for the last three years
Arbitrage trading is like hedging, which is done to eliminate risk. However, it is not completely risk-free. These returns from Arbitrage fund don’t look high but keep in mind that as the investment is done in equity, they have zero tax if you keep them for more than 1 year. The returns are comparable to fixed deposits and with the income tax benefits, you can make even more than FD with them.