# What is Arbitrage and how it plays an important role in the market?

Chirag Singhal , 30 December 2016

Market is full of trading techniques. Those trading techniques are development to overcome the loopholes in an industry. And development is nothing but a demand of time.

Here we will be discussing one of those trading method of the finance industry known as Arbitrage. From this article, one will come to get a brief idea of what is arbitrage and how the market remains stable because of Arbitrageurs (people who do arbitrage).

We will discuss Arbitrage in 2 phases: Basic and Explanations which are discussed below.

BASICS:

What is Arbitrage?

In a simple language, earning the profit on the same/identical asset due to the price difference between same/different market. The person who does arbitrage is known as Arbitrageur.

Let us simplify this definition. There are 2 parts to it:

• SAME ASSET & DIFFERENT MARKET
• DIFFERENT ASSET (BUT IDENTICAL) & SAME MARKET

SAME ASSET & DIFFERENT MARKET

For understanding the definition let us take an example:

Why people export their products? When we have such big country, with so many states and with such large population, why does a need arise to export in foreign country?

Out of the many reasons, the main is the price we get over there. We know that a 1 USD= 68 INR (approx.). We must also understand that just like we don’t value a Re. 1 currency, so would the Americans won’t value their \$ 1. But for us \$ 1 is Rs. 68, which is something any Indian would value.

So due to this price difference, people sell their products in foreign country in order to get a higher price.  This gets them higher price for the same product just by changing the market.

Now, suppose there is a trader named Mr. A who buy goods from India and sell it to USA.  He buys at Rs. 60 and sell the same product at Rs. 100. So, the difference of Rs. 20 is the gross profit he earns because of the price difference.

Out of Rs. 20, he has to deduct the direct & indirect expenses (e.g.: custom charges, transport charges, etc.) and then he would arrive at a net profit of let us say Rs. 10.

Similar is the nature of arbitrage. Comparing our example with Arbitrage--

The trader Mr. A is the arbitrageur.

The product which he trades is the asset (e.g.: Shares, Options, etc.)

USA and Indian markets are the stock exchanges in USA (e.g.: New York Stock Exchange) and India (e.g.: NSE) respectively.

The gross profit is the profit/premium earned due to price difference.

The expenses are the transaction charges and stock broker’s commission.

The net profit is the net premium/profit earned by the Arbitrageur.

DIFFERENT ASSET (BUT IDENTICAL) & SAME MARKET

Let us take an example to understand it better.

Suppose Mr. B is a trader of fabrics in India. He buys such fabric, let us name it as A1 fabric at Rs. 60 and sell it at Rs. 70. He earns Rs. 10 on this type of trading in India. He founds that a similar type of fabric known as C1 fabric is available at a comparatively lower price. But the fun with it is that when there is summer season the A1 fabric is easily available, while in other seasons the C1 fabric is easily available. We know that we get a product which is easily available in market at a low price in comparison to the product which is not easily available.

Seeing this opportunity, Mr. B starts buying A1 fabric and sell C1 fabric in summer. While he buys C1 fabric and sell A 1 fabric in other seasons. This gives him a higher price difference by taking the opportunity of the seasonal changes.

Comparing our example with the world of Arbitrage--

The trader Mr. B is the arbitrageur.

The fabric which he trades is the asset (e.g.: Shares, Options, etc.)

Seasonal changes are the changes(increase/decrease) in value of NIFTY500 and SENSEX of Indian stock market.

NIFTY and SENSEX are the reflectors of the stock market. When they are rising, we say that the Indian market is going up (i.e. bullish market) and when they are going down, we say that the Indian markets are not performing well (i.e. bearish market).

Every share is affected with changes in the market. It may be the same effect or the opposite effect.

Same effect:
If share price of a company rises when NIFTY rises and if they decrease when NIFTY decrease, then it means that it react the same way as the market.

Opposite effect:
If share price of a company rises when NIFTY decreases and if they decrease when NIFTY rises, then it means that it react the opposite way of the market.

The benefit of different effects is taken by the Arbitrageur.

HOW ARBITRAGEURS PLAY AN IMPORTANT ROLE IN STABLING THE MARKET?

Arbitrageurs are the group of people who maintains control which keeps the market stable.

How?
Arbitrageurs do the exact opposite way of the ongoing trend. They buy the asset when people are actually selling it and sell the asset when people are actually buying it.

Why opposite?
A normal trader would think that what will the Reliance share give him after some time if he invest in those shares today. While Arbitragers target the difference they will earn from certain combinations.

What kind of combinations?

Combinations such as same share in different market or identical share in same market. They would either buy Reliance in NSE and sell it in other stock exchange or buy Reliance and sell TATA and vice versa. They keep on rolling over their positions and at the end square off everything.

As they compare 1 asset with another in same market or different asset in same market, they always look for the difference between the prices.  Hence, they react the exact opposite way of what the people does, in order to earn a difference.

What is rolling over position?
Buying what I have sold and selling what I have bought.

What is square off?

When I sell something which I bought earlier I have no stock with me. And when I buy something for a future assured sell, I again remain with no stock. This is squaring off.

Arbitrageurs always end up with some profit in their hand. Arbitrageurs never make a loss unless and until the transaction cost is more than the difference they earn. Further, if they don’t react the opposite way then if there is a buying trend, people would keep on buying and in a selling trend, people would keep on selling. This would result in a very high instability in the market.

IS ARBITRAGE POSSIBLE IN A PERFECT MARKET?

There are very less arbitrage opportunities in a perfect market. In a perfect market, at every place the asset is of same price and there remain no space to earn the price difference.

“Arbitrage brings stability in an imperfect market. As the market start becoming mature/perfect, arbitrage opportunities would keep on decreasing and vanish one day.”

At the end Arbitrageurs are never a long term shareholders. Because they keep on rolling over their position.

By rolling over their positions, at the end they neither remain the seller nor the buyer, and take the profit of the price difference home.

They just work like shadows who are very much responsible for the market stability.

Chirag Singhal
(Finance Professional)
Category Others   Report

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