What is Arbitrage in the stock market?

Arbitrage is a trading strategy that aims to profit from price discrepancies of identical or similar assets across different markets. This strategy capitalises on the principle of market efficiency, where the same asset should have the same price across all markets. Arbitrageurs exploit deviations from this equilibrium to earn risk-free profits.

Types of arbitrage

• Spatial Arbitrage: This involves exploiting price differences of the same asset in different geographical locations. For instance, if gold is priced lower in one country compared to another, arbitrageurs may purchase gold in the cheaper market and sell it in the higher-priced market, pocketing the difference as profit.
• Temporal Arbitrage: Temporal arbitrage capitalises on price differences of the same asset over time. For example, if the price of a stock is expected to increase in the future, arbitrageurs may buy the stock at the current price and sell it later at a higher price, realising a profit.
• Statistical Arbitrage: Statistical arbitrage relies on quantitative analysis and statistical models to identify mispriced assets. Arbitrageurs use complex algorithms to analyse historical price data and identify patterns or anomalies that can be exploited for profit.

Example of arbitrage in the stock market

Let's consider a scenario where the futures contract for a particular stock is trading at Rs. 1050, while the spot price of the same stock in the cash market is Rs. 1045. In this situation, an arbitrageur could:

1. Buy the stock in the cash market at Rs. 1045 per share.
2. Simultaneously sell short the futures contract at Rs. 1050 per share.
3. Hold the position until the futures contract expires.

At the expiry of the futures contract, the spot price and futures price should converge. If the spot price remains at Rs. 1045, and assuming no transaction costs, the arbitrageur would profit from the Rs. 5 difference between the spot and futures prices.