Arbitrage trading is the buying and selling of financial securities on two different exchanges in a given day. Traders make profits on the value difference between the two indexes, or even markets. For instance, one can exchange USD (US dollars) for INR (Indian Rupees) at a different exchange price in New York than Mumbai. It is usually done for the entire duration of day and is getting increasingly popular all over the world. Unlike statistical arbitrage, which does not guarantee profits, arbitrage trading delivers profits usually, regardless of the profit margin.
One of its essential characteristics is that while the securities must be traded at two distinct rates, buying and selling of the instrument should be simultaneous. Trading at the same time is crucial because it obliterates the perils of holding on to as security for too long. Traders adopt different arbitrage strategies to calculate the difference in prices of securities in two exchanges, and then trade accordingly. Although it is easy to become successful in arbitrage trading, the system does have its share of intricacies. Newcomers would do well to make themselves familiar with the basics of stock/security and forex arbitrage also known as currency arbitrage trading.
Arbitrage trading is also frequently done between the S&P500 and the S&P500 futures. The trading price on these two indexes is different on most trading days. This is because the stock prices usually traded over NASDAQ or NYSE markets lag behind or move ahead of the S&P Futures. In case the futures price lags behind the stock market prices, arbitrage traders would quick to seize the arbitrage opportunity and purchase the futures after selling the stocks. They would have made some money despite owning similar instruments on the very same day. Expert traders know exactly when to go short or trade long and at what prices.
Let us take another example of a firm, which announces a positive development through a press conference. Its stock price begins to increase on the NYSE, whereas the stock’s call options in the AMEX remain largely undisturbed. Astute arbitrage traders would be smart enough to notice this discrepancy and waste no time in selling the shares while buying call options (almost simultaneously). However, one needs to be quick on their feet to be able to take such crucial decisions since the prices of financial instruments change within a few seconds.
In many cases, arbitrage trading does guarantee profits but the margins are so small that it sometimes becomes impractical and unfeasible. For the same reason, it is the safest means of security trading with minimal risks. The element of risks arises in only those cases where arbitrage trading is done in different time zones wherein one market closes and the other opens. This in turn, exposes the trader to a one-sided market.
One of the myths surrounding arbitrage trading is that it encourages pricing manipulation. In reality, it merely allows traders to take advantage of the price difference between two indexes using the demand and supply principle. According to this time-tested system, price of an instrument goes up when demand exceeds supply, and comes down when the supply overtakes demand. All a buying arbitrage trader does is to purchase when supply is greater than demand. Similarly, an instrument is sold when its price goes up as a result of excessive demand.
For newcomers, it is always prudent to use simple arbitrage strategies as opposed to the complex ones, which are used in real estate trading and forex arbitrage. They must also follow the Arbitrage Pricing Theory propounded by Stephen Ross back in 1976 as per which, the anticipated return of an instrument or security depends upon a number of macro-economic factors like inflation/deflation, industrial production, GDP figures and investor confidence, among others.