The opportunities for arbitrage lie in price deviations among asset classes. But how does arbitrage work? And what are the limitations? Let's look at the meaning, trading style, and limitations in arb
While talking about market participants, one usually refers to either long-term investors or intra-day traders, conveniently leaving out a third category – that of arbitrageurs.
Arbitrageurs are the traders who undertake risk-less trades across global markets through a method known as arbitrage.
Now, what is an arbitrage?
Simply put, arbitrage is a trading practice wherein one buys an asset from one market and sells it in another market to make a quick buck.
The practice exploits the assumptions of "efficient market" theory which suggests that a security or an asset, offering similar returns and having similar risks, should be valued at the same price across markets.
However, as we know, prices can vary across markets due to factors like different foreign exchange rates, supply constraints, or demand exuberance.
Thus, when price of a security is low in one market and high in another, arbitrageurs undertake trades to make "risk-less" profit.
If one ounce of gold trades at $1,700 in one market and at $1,780 in another, an arbitrageur can easily earn profit of $80.
Further, take a closer look around you and you would notice that arbitrage opportunity exists even at local levels.
For example, if a loaf of bread is sold at Rs 30 in Delhi and at Rs 35 in Noida, then someone interested in bakery business can easily earn a profit of Rs 5 per loaf by buying in Delhi and supplying it in Noida.
In the stock market, too, there is an opportunity for arbitrage in a scrip. However, such opportunities are usually rare.
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