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

Arbitrage trading is a time-tested strategy that allows investors to profit from price differences of the same asset across different markets. By buying low in one market and selling high in another, traders can earn risk-free gains if they act quickly and efficiently. While often used by professionals, arbitrage is now accessible to individual investors through arbitrage mutual funds. 

What is arbitrage?

Arbitrage is an innovative trading strategy that allows investors to capitalise on price differences for the same asset across different markets. It involves buying an asset such as stocks, commodities, currencies, or futures from one exchange where the price is lower than others, and then selling it on an exchange with a higher price. The price difference between the two exchanges is the trader's profit.

Such opportunities arise when there's a mismatch in how different markets value the same asset. This can happen due to slight variations in supply and demand, investor mood, trading volume, or even time zone differences between exchanges. For instance, a stock might momentarily trade at ₹1,000 on one platform while valued at ₹1,020 elsewhere.

Arbitrageurs spot these tiny gaps and act quickly, buying where it's cheaper and selling where it's higher before the prices realign. While the profit margins are often small, the strategy is designed to be low-risk and repeatable. At its core, arbitrage is about being faster and sharper than the market.

What is the arbitrage process? 

Imagine that shares of XYZ Company are trading at ₹200 per share on the Bombay Stock Exchange (BSE). At the same time, the same stock is listed on the National Stock Exchange (NSE) at the equivalent of ₹212 per share in Indian Rupees.

This price difference opens up an arbitrage opportunity. A trader could purchase 1,000 shares from the BSE, spending ₹2,00,000 total. Simultaneously, they could sell those 1,000 shares on the NSE for ₹2,12,000, pocketing a neat profit of ₹12,000 without any change in the asset itself.

While the principle seems straightforward, timing and execution are critical. These price mismatches often last just a few seconds before markets adjust. Successful arbitrage involves identifying the gap early, acting quickly, and closing the trade before others catch on.

How does arbitrage trading work in India?

Arbitrage trading is permitted in India but comes with certain regulatory boundaries. According to SEBI (Securities and Exchange Board of India) guidelines, traders are restricted from buying and selling the same stock on different exchanges simultaneously within the same day unless they take delivery of the shares. This means intraday cross-exchange arbitrage without delivery is not permitted.

To legally execute arbitrage in India, you must already hold the stocks in your Demat account. If you notice a price difference for that stock across exchanges, say, it’s priced higher on the NSE and lower on the BSE, you can sell your existing holdings on the exchange offering a higher price. After that, you may repurchase the stock from the exchange where it’s cheaper, thereby replacing your inventory and booking a profit.

This process ensures compliance with SEBI’s delivery-based rules while allowing traders to benefit from short-term price inefficiencies in the market.

What is an arbitrage fund?

An arbitrage fund is a hybrid mutual fund that aims to generate low-risk returns by exploiting price differences between the cash and futures markets. Fund managers buy stocks in the spot market and sell them in the futures market to capture the price spread.

These funds are market-neutral and typically unaffected by overall market direction, making them suitable for conservative investors. The fund may allocate assets to debt or money market instruments when arbitrage opportunities are limited.

Arbitrage funds are considered equity-oriented for taxation. If held for over a year, they offer better post-tax returns. They are a smart alternative for short-term stability with minimal market exposure.

How do arbitrage funds work?

Arbitrage funds aim to profit from short-term price differences between the cash and futures markets. Fund managers buy stocks in the spot market and sell them in the futures market when the futures price is higher. This difference, or spread, becomes the fund’s return.

Since individual price gaps are usually small, the fund conducts several such trades daily to generate meaningful returns. When market conditions are unfavourable for arbitrage, the fund may invest in debt or money market instruments to maintain stability.

Example:

Arbitrage opportunities tend to increase during volatile markets, making arbitrage funds suitable for conservative investors seeking steady returns without high market risk.

Arbitrage pricing theory

Arbitrage Pricing Theory (APT), introduced by economist Stephen Ross in 1976, explains that an asset’s expected return is influenced by multiple macroeconomic factors like interest rates, inflation, and GDP growth rather than overall market risk. If a security’s market price deviates from its fair value based on these factors, it creates an arbitrage opportunity.

While arbitrage funds don’t directly use APT, the theory supports their core idea that temporary price inefficiencies exist in the market. Fund managers aim to capitalise on such short-term mispricings to generate low-risk returns.

Examples of arbitrage funds in India

Listed below are some of the best arbitrage funds in India, based on their 5-year and 3-year annualised returns as of May 5, 2025

Arbitrage funds taxation in India

Arbitrage funds are treated as equity mutual funds for taxation since they invest at least 65% of their portfolio in equity or equity-related instruments. This classification allows them to enjoy the tax benefits associated with equity schemes.

• If the units are sold within 12 months, the gains are classified as Short-Term Capital Gains (STCG) and taxed at a flat rate of 20%.
• If the units are sold after 12 months, the gains fall under Long-Term Capital Gains (LTCG). In this case, returns exceeding ₹1 lakh in a financial year are taxed at 10% without indexation, but many funds apply effective taxation around 12.5%.

This equity-like tax treatment makes arbitrage funds an attractive choice for conservative investors. They offer low volatility and better post-tax returns than traditional debt instruments, especially over short to medium investment horizons.

Conclusion

Arbitrage trading is about spotting price differences and making the most of them without taking significant risks. Unlike regular equity investments that fluctuate with the market, arbitrage funds take a calm, calculated approach, buying at a lower price in one place and selling at a higher price elsewhere to generate steady returns. For investors seeking peace of mind and performance, these funds offer a smart way to grow wealth, especially during volatile market conditions. With the benefit of favourable equity taxation, arbitrage funds combine stability, efficiency, and tax-friendly gains in one low-risk investment, making them a sensible choice for cautious yet growth-minded investors.