What Is Arbitrage in Stock Market?

Arbitrage is a strategy used in the stock market to take advantage of price differences of the same asset across different markets or forms. It involves simultaneously buying and selling an asset to profit from a discrepancy in its price in two or more markets. Arbitrage is a mechanism that helps in maintaining market efficiency by ensuring that prices do not deviate substantially from their true value for long periods.

How Arbitrage Works

The core idea behind arbitrage is to buy low and sell high, but this is done almost simultaneously in different markets or in different forms (e.g., spot vs. future prices) of the same asset.

Example:

Consider a scenario involving Infosys shares. If Infosys shares are trading at ₹950 on the Bombay Stock Exchange (BSE) but at ₹955 on the National Stock Exchange (NSE), an arbitrageur would buy the shares at BSE for ₹950 and sell them at NSE for ₹955, securing a profit of ₹5 per share before any transaction costs.

Types of Arbitrage

• Spatial Arbitrage: Involves exploiting price differences between geographical locations or different exchanges.
• Temporal Arbitrage: Capitalizes on price discrepancies over time, such as futures contracts being priced differently from the spot price.
• Statistical Arbitrage: Uses complex mathematical models to identify and exploit brief anomalies in prices or trends.

Key Elements of Arbitrage

• Speed: With today's technology, price differences across markets are identified and rectified within seconds, making speed crucial.
• Risk-Free Profit: Ideally, arbitrage is considered risk-free, as the transactions are designed to exploit price differentials without market risk.
• Market Efficiency: Arbitrage plays a vital role in improving market efficiency by eliminating price discrepancies.

Challenges and Risks

While arbitrage is often considered a low-risk strategy, it does come with its challenges and potential risks:

• Transaction Costs: Profit from arbitrage might be eroded by transaction fees, taxes, and other costs.
• Execution Risk: Fluctuations in price during the execution of trades can lead to losses instead of profits.
• Competition: The availability of arbitrage opportunities has decreased over time due to high competition and advanced trading technologies.

Conclusion

Arbitrage is a sophisticated trading strategy that capitalizes on price discrepancies of an asset across different markets. While traditionally considered low risk and a mechanism for ensuring market efficiency, arbitrage requires rapid execution and careful consideration of transaction costs and execution risks. With the advancement of technology and increased market surveillance, arbitrage opportunities have become less common and more challenging to exploit, but they still offer valuable insights into the mechanics of financial markets and the concept of market efficiency.