Arbitrage Trading: Meaning, How it Works & What Are Arbitrage Funds

When it comes to trading in the stock market, there are several methods which one may follow. Among them, one age-old practice is arbitrage trading. Keep reading to learn more about this trading strategy and much more! 

What is arbitrage?

Arbitrage is a trading tactic in which individuals profit from the difference in asset prices on two different exchanges. It involves purchasing assets like stocks, commodities, currencies, futures contracts, etc., from one market/exchange and selling them in another, where they are trading at a higher price. 

These opportunities arise as the investor sentiments across markets are not completely similar. Due to discrepancies in the demand and supply of assets in different markets, their prices tend to differ, giving traders a chance to perform arbitrage trading.

What is the arbitrage process? 

Let’s take an example to understand the process. 

Suppose the shares of Angel Manufacturers Ltd. are listed on the Bombay Stock Exchange (BSE) at Rs.200/share. Now, the same stocks are listed on the Toronto Stock Exchange (TSX) at a price equivalent to Rs.212/share in INR. 

Now, to take advantage of this arbitrage opportunity, you buy 1000 shares of the company from the BSE and sell the equivalent number of shares on the TSX. Thus, you purchase shares for Rs.2,00,000 from one exchange and sell them for Rs.2,12,000 on the other, thereby earning a profit of Rs.12,000. 

How does arbitrage trading work in India?

Arbitrage trading is legal in India; however, there is a catch. SEBI does not allow buying and selling the same company’s stocks on the same day on different exchanges. Moreover, for the trade to be deemed legal, you must take delivery of the shares. 

Thus, to perform arbitrage trading in India, you must have the target stocks present in your Demat account. Under such circumstances, if you spot a price difference on either of the stock exchanges, you can sell them in order to book the profits. Then, you can buy back the shares from the exchange, which has a lower price, to facilitate their delivery. In this way, you earn profits and adhere to SEBI’s guidelines.   

What is an arbitrage fund?

Arbitrage funds are hybrid mutual funds that primarily invest in equity assets. They aim to leverage the price differences between assets on two exchanges or the cash and futures markets. 

How do arbitrage funds work? 

As gains from arbitrage transactions are usually very low, the fund manager of an arbitrage fund has to simultaneously conduct several trades each day in order to generate profits for the investors. If no such opportunities are available, these funds invest in debt securities and short-term money market instruments.   

Now, arbitrage opportunities are more likely to be available when the markets are volatile. Thus, investors with a low-risk appetite can consider purchasing units of such funds during times of fluctuation to generate profits. 

Arbitrage pricing theory

The arbitrage pricing theory was developed in 1976 by an American economist, Stephen Ross. It states that the future price of an asset can be computed based on the linear relationship between its expected returns and macroeconomic factors that can affect its associated risk. 

Investors can use this hypothesis to analyse stock portfolios and identify underlying assets of arbitrage funds that face temporary price discrepancies across markets. 

Examples of arbitrage funds in India

Listed below are some of the best arbitrage funds in India, based on their 5-year annualised returns as of May 2, 2023:

Arbitrage funds taxation in India

As per Indian tax laws, arbitrage funds are treated as equity schemes. Thus, the profits you gain from selling these fund units are subject to Capital Gains Tax. If you sell the assets within one year from the date of purchase, Short Term Capital Gains (STCG) tax of 15% is applicable. 

However, if you sell the units after holding them for a year or more, Long Term Capital Gains (LTCG) tax would be applicable. The tax rate is 10% for profits exceeding Rs.1 lakh.  

Final Word

Now that you have a fair idea of arbitrage meaning in the stock market, you can plan your trades accordingly to take advantage of such opportunities. However, before you proceed, please remember that chances to perform arbitrage trading only appear for a short duration. 

Furthermore, like any other trading activity, arbitraging will also include transaction charges. So, please ensure that the profits from such opportunities are high enough to cover these expenses.  

Frequently Asked Questions

What is arbitrage, with example?

Suppose International Telecom Ltd. stocks are trading on BSE at ₹218/share, whereas, on the NSE, they are trading at ₹222 for each share. So, you buy 1000 shares of this company from the BSE and sell them on the NSE to take advantage of the price difference. This is called arbitrage trading.   

What is arbitrage in simple words?

To explain in simple terms, an arbitrage involves leveraging the price difference of an asset listed on different exchanges. These opportunities generally occur due to the discrepancies in the demand and supply of securities on various platforms.  

Is trading arbitrage illegal?

As per SEBI rules, arbitrage trading is legal only if you take stock delivery. This type of activity is encouraged as it helps even out price discrepancies of an asset across various markets, thus ensuring it has the same value. 

Is arbitrage legal in India?

Yes, arbitrage trading is legal in India as long as you are taking delivery of shares. SEBI promotes such activities as it helps keep the prices of securities the same across different exchanges. 

What is arbitrage in trading?

In trading, arbitrage is the process of buying an asset from an exchange where it is listed at a lower price and selling it on another in which it has a higher value.