Who is an Arbitrageur?

Just like you have intraday traders, short-term traders and long-term investors, an important organ of the market is the arbitrageurs. They are important for a variety of reasons. For example, they create liquidity and volumes in the market and narrow mispricing spreads. Let us understand the arbitrageur definition and what is an arbitrageur. We also look at who is an arbitrageur and what does the arbitrageur in the stock market does.

The arbitrageur in the stock market is a very critical link between asset prices and helps to equalize them across markets or at least synchronize the prices. To understand who is an arbitrageur and the role of arbitrageur in the stock market, let us look at his role in greater detail.

Who is an Arbitrageur?

It happens quite often that there is mispricing between the spot and futures price or there is mispricing between the price of the same in-stock in two markets. At times the price of the same underlying in different markets is different. For example, often you get to see a divergence ineffective price between the Nifty in India and the SGX Nifty in Singapore. Sometimes the price of a stock in the cash market is lower and sometimes it is higher compared to the similar asset price. That is where the arbitrageurs come in and exploit these imperfections and inefficiencies to their advantage. Arbitrage trade is a low-risk trade where a simultaneous purchase of securities in one market and a corresponding sale in another market.

In India, a popular form of arbitrage exploits the gap between spots and futures in the equity market. Here is why. In Indian markets, there is no delivery of shares to settle positions in the derivatives segment. As a result, the spot price and the futures prices converge on the expiry day. This creates what is called a mug’s game arbitrage where you just need to buy the spot and sell in the futures whenever the arbitrage spread is interesting. For example, if you buy a stock at Rs.1000 and sell the futures of the same month at Rs.1010, then you are getting an assured return of 1% in a month which, if annualized comes to more than 12%. That is exactly the job of the arbitrageur.

Simultaneous buying and selling is the key

An arbitrageur is, therefore, a person who exploits differences in the price or anomalies in the pricing of a given stock by simultaneously purchasing and selling that security. The focus here is on the word simultaneously since it cannot be a break trade or a two-leg trade as that would beat the basic purpose.

Let us now turn to the arbitrage working. Assume that there is a company X whose stock trades at Rs.500 per share on the NSE. At the same time, the equivalent price is Rs.520 on the BSE. Now, this is practically very rare, but let us assume for the sake of argument. The arbitrageur would purchase the stock of X for Rs.500 on the NSE and sell it on the BSE for Rs.520. He will thus pocket Rs.20 or 0.40%. That is not a bad return for a one or two days trade.

Arbitrageurs also try and exploit price differences created by mergers, conversions of convertibles, etc. In some cases, they purchase the shares of companies that are the merger or acquisition targets and simultaneously sell the stock of the acquiring company to capitalize on price anomalies. In theory, arbitrage is a riskless activity, but merger arbitrage is not exactly riskless and it is a lot more statistical in nature.

Let us also understand why do arbitrageurs matter?

Institutions are normally the principal arbitrageurs in any market and India is no exception. The large volumes of shares they trade can make millions in profits even if the spread is small. Also, they have access to advanced algos and the facility of low latency trades, which are mandatory for a successful arbitrageur trade.

The main creator of arbitrage opportunities used to be a lack of real-time communication about prices in other markets, but technology has reduced the number of arbitrage opportunities substantially in the last few years with scores of institutions using high-end computing and artificial intelligence, and whatnot. The relatively few arbitrage opportunities that exist are elusive and don't last for long. In a sense, arbitrageurs ensure equilibrium in the markets and that is why they matter so much to markets.

What is Arbitrage?

Arbitrage can be defined as the simultaneous purchase and sale of the same asset in different markets. The idea of an arbitrage trade is to profit from tiny differences in the asset's price. In a nutshell, arbitrage exploits short-lived variations in the price of identical or similar financial instruments across different markets, different maturities, different strokes, different related assets, etc. Not all arbitrage is risk-free, but it does contribute in a big way to making markets efficient. Arbitrage exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them.

In short, there are some key takeaways from arbitrage. Firstly, arbitrage is the simultaneous and synchronized purchase and sale of an asset in different markets to exploit differences in prices using technology-driven execution. Secondly, arbitrage trades are made in stocks, commodities, and currencies. In short, arbitrage is asset agnostic. Lastly, arbitrage takes advantage of the inefficiencies in markets and makes small profits on large volume trades

Types of Arbitrage

Some of the popular types of arbitrage can be summarized as under:

  • Cash-futures arbitrage
  • Statistical arbitrage
  • Convertible arbitrage
  • Fixed-income arbitrage
  • Political arbitrage
  • News based arbitrage
  • Triangular arbitrage
  • Risk-based arbitrage
  • Macro arbitrage
  • Volatility arbitrage
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