Different Types of Arbitrage in Share Market
The strategy that enables traders to buy and sell the same asset in different markets to earn money from price differences is known as arbitrage. This strategy ensures market efficiency by resolving price differences. However, many types of arbitrage possess unique features and perform distinctively in the share market. Statistical, convertible, financial, and risk arbitrage are some of its examples. In this blog, you will understand the types of arbitrage, its advantages, and the risks associated with them. So let’s dive in and discuss arbitrage in detail.
Key Highlights
- Arbitrage is a strategy that enables investors to trade the same asset in different markets to earn money from price differences.
- There are many types of arbitrage, for example, statistical, convertible, financial, and risk-associated.
- Arbitrage trading offers advantages like risk-free profits, market efficiency, diversification, low volatility, and quick execution.
- There are some risks involved in arbitrage trading like execution risks, market liquidity, transaction costs, technology risks, and regulatory and compliance risks.
Table of Contents
What are the Types of Arbitrage?
There are various types of arbitrage offering different features to investors. Here is a list of the common arbitrages and their working process:
Statistical Arbitrage
Statistical arbitrage is a trading tactic that relies on mathematical models and data analysis. It detects patterns within price movements to capitalise on them. This approach uses high-frequency trading and complex algorithms to foresee and make a profit from sudden changes in the market. Therefore, improving choice-making in trading while at the same time assuring consistency.
Risk Arbitrage
Risk arbitrage involves trading stocks in firms engaged in acquisitions or mergers. In this kind of arbitrage, traders purchase securities in the target firm and dispose of those of the acquirer. This is done to make money from price differences that evolve as the transaction unfolds.
Convertible Arbitrage
Convertible arbitrage involves taking advantage of price differences of a company’s convertible securities compared to its basic stock. The goal is for traders to sell short the underlying stocks and then purchase convertible bonds. This is done to take advantage of price inefficiencies that exist to ensure lower risks.
Financial Arbitrage
Arbitrage in finance is the act of exploiting price differences between different financial instruments in various markets. The traders purchase low from one market and sell at a higher price on another. This enables them to make gains through the fluctuation between prices. Such a strategy contributes towards better market efficiency and the balancing out of rates.
Advantages of Arbitrage Trading
There are many benefits associated with arbitrage trading. Let’s discuss each one in detail.
- Risk-free Profits: Arbitrage trading aims to exploit price discrepancies across different markets, leading to risk-free profits.
- Market Efficiency: Arbitrage trading helps promote market efficiency by reducing price discrepancies and bringing prices closer to their fair value.
- Diversification: Arbitrage trading allows investors to diversify their portfolios by participating in multiple markets and taking advantage of various opportunities.
- Low Volatility: Arbitrage strategies often involve short-term trades, resulting in lower exposure to market volatility than long-term investments.
- Quick Execution: Arbitrage trades are typically executed swiftly to capitalise on fleeting price differences, allowing quick profits.
Risks of Arbitrage Trading
Along with benefits come risks as well. Similarly, there are some risks associated with arbitrage trading. Let’s discuss them in detail.
- Execution Risks: Delayed execution or inability to execute trades at the desired price can lead to missed opportunities and potential losses.
- Market Liquidity: Insufficient liquidity in certain markets can make entering or exiting trades quickly challenging, impacting arbitrage strategies.
- Transaction Costs: Transaction costs, such as brokerage fees and exchange charges, can eat into potential profits and affect the overall profitability of arbitrage trading.
- Regulatory and Compliance Risks: Different markets may have varying regulatory requirements, and failure to comply with these regulations can result in penalties or legal issues.
- Technology Risks: Dependence on technology for real-time data, order execution, and trade monitoring introduces the risk of technical glitches or system failures that can disrupt arbitrage strategies.
Conclusion
Various types of arbitrage exist in the stock exchange: risk, statistical, convertible, and financial arbitrage. Understanding these differences gives you insight into how traders take advantage of price differences for their gain. Moreover, its advantages include increasing market efficiency and making profits. However, arbitrage trading also has its risks that include fluctuations in prices and problems when carrying out transactions among others. By knowing these pros as well as cons, investors can make sound choices on how best they can manage their investments. Therefore, acknowledging these concepts helps create a more reasonable and effective system of finance.
FAQs on Different Types of Arbitrage in Share Market
Yes, it is feasible to perform arbitrage by purchasing a listed security on NSE and selling it on BSE. This depends upon whether there are significant price variations or not. The method takes advantage of different prices among stock exchanges which enables speculative traders to profit from them.
Yes, arbitrage is legal in India. It involves taking advantage of the difference in pricing between diverse markets or instruments. Moreover, it is allowed under the Indian laws on securities. However, it must follow the rules and regulations of the market for fair trade practices.
Assuming that a cement company’s stock is trading at Rs. 100 on BSE when the same stock is going for Rs. 100.50 on NSE. Thus, an arbitrageur would quickly buy shares from BSE before selling them on NSE to make a profit of fifty-half-rupees per share.
The most widely used arbitrage tactic is that of simple arbitrage. This type of arbitrage allows traders to exploit price differences for the same item in various markets. This method entails purchasing the asset at a lower rate from one marketplace and vending it at a higher cost in another.