Traders and investors are always on the lookout for avenues that can increase their profits and generate additional revenues. Arbitrage is an alternative investment strategy employed by investors to make the most of the assets and commodities they are holding. This, however, is a tricky financial strategy, as it relies on very short-lived price fluctuations and must, therefore, be used briskly yet smartly to ensure maximum gains for the investor.
In this article, we look at the different types of arbitrage strategies, their importance, and what they entail.
What is arbitrage
Arbitrage is an age-old strategy wherein an investor buys and trades assets, commodities, and other financial instruments in two different markets simultaneously. The key here is that the investor profits from the price differences of these instruments in the two markets. The general idea is that assets should have the same price across markets. However, due to certain factors, such as changes in policy or interest rates, prices can fluctuate, and arbitrageurs identify these movements and profit from them.
Types of arbitrage
Arbitrage trading offers a highly flexible way to enhance revenues in the market. The versatility offered by this trading mechanism has led to the emergence of different types of arbitrage. These include the following:
Pure arbitrage
This is the most common form of trading in which an investor purchases an asset for some price in one market and sells it in another market where the price of the same asset is higher. For example, an investor buys stock in a company at Rs. 45 per share in Market A and sells it for Rs. 52 in Market B (where the same stock is priced higher), making a profit of Rs. 7 per share.
Retail arbitrage
Here, a trader buys a product from a local retailer at a lower price and sells it online at a higher price. This type of trading usually happens in physical goods, such as clothes and machinery, and is driven by the opportunities created by e-commerce platforms.
Risk arbitrage
This type of arbitrage involves risk because the investor buys a certain stock in one market at a particular price with the expectation that its price will rise in another market in the future. The investor essentially buys and holds the stock, which can turn into a huge opportunity cost if the stock price does not rise sufficiently in the future.
Convertible arbitrage
In this case, convertible bonds or notes, which are essentially debt instruments issued by corporate entities, are traded. Arbitrageurs seek to take advantage of the difference between the conversion price of the bond and the price at which the company’s shares are currently being traded. To achieve this, investors take long and short positions simultaneously, depending on how they perceive the pricing of the bond.
Merger arbitrage
This form of arbitrage is implemented by investors when they anticipate a merger of two companies. The tactic involves an investor purchasing stocks of the company being bought (the target company) at a discounted price and selling them at a higher price once the acquisition is completed successfully.
The reason for the discounted price is the consideration of the possibility that the merger may not go through or get cancelled. This could also be a sub-type of merger arbitrage where the investor expects the merger plan to fail and may short the stocks of the target company.
Dividend arbitrage
Investors engaging in this kind of arbitrage buy stocks of a company just before its ex-dividend date, which is the last date on which a buyer can demand a dividend payout from the company. Arbitrageurs time their purchases correctly to capitalise on the dividend and increase their returns.
Futures arbitrage
As the name suggests, this type of arbitrage takes place in the futures market. The strategy requires a trader to buy stocks in exchange for cash and then sell them at a higher price in the futures market. While futures are priced higher than cash, the eventual conversion of prices in the two markets as the expiration date approaches generates an arbitrage opportunity that investors seek to tap.
Conclusion
Arbitrage trading is a complex financial strategy and only the most seasoned players are able to employ it effectively. Arbitrage trading requires a holistic and detailed understanding of the market, in-depth research, and seamless execution of the trade. At the same time, the different types of arbitrage that operate make new investment opportunities available for risk-averse investors or traders looking for low-risk returns. This is because the investor is usually aware of the buying and selling prices of the commodity and is, therefore, assumed to be making an informed decision.
Another advantage of arbitrage is the immediate nature of the trade. In the case of a bond, for instance, its returns heavily depend on its future performance. Arbitrage trading happens quickly and swiftly, delivering substantial profits in the process.
On the other hand, while allowing quick profits, arbitrage relies on volume trading, which makes it difficult for individual investors to engage in this type of trading. As a result, large hedge funds or reputed institutional investors participate in the arbitrage market. Furthermore, since trading markets are strictly regulated, investors need to consider compliance costs and regulatory constraints before diving into arbitrage.
