Arbitrage Trading: Example, Introduction, Overview-1

In this article, I will attempt to introduce the concept of “Arbitrage Trading”

What is Arbitrage Trading? How does arbitrage trading works? How to make profit from Arbitrage Trading? What are the risks with Arbitrage Trading?

Arbitrage trading literally means “Risk Free Profit” . A similar concept can be extended as “Free Lunch” or “Free Money Making Machine”.
Across the globe, traders and market makers attempt to get this risk free profit while attempting to do arbitrage trading.

Let’s take an example:
Let’s say a stock XYZ is listed on 2 stock exchanges: NASDAQ as well as NYSE (Same like Reliance is listed both on NSE and BSE).

So as an arbitrage trader, I attempt to benefit from the stock price difference between the two stock exchanges for the same XYZ stock. Let’s say the XYZ stock is trading at $20 on NASDAQ, and at the same moment, the price at NYSE for XYZ is $20.50. Hence, I spot this price difference, and buy XYZ stock on the exchange where it is available for cheap, and immediately sell it at the exchange where it is costlier.

In the above example, I’ll buy 100 shares of XYZ on NASDAQ with a BUY price of $20 and immediately sell 100 shares at NYSE for $20.5. Hence, in the process (if everything goes well), I make $0.5 per share, or 100 shares * $0.5 = $50 on the trade, within less than a minute.

So, at the end of this exercise, I will have ZERO position in XYZ stocks, i.e. RISK FREE (as I’m not holding anything), and still I make a profit – that’s why RISK FREE PROFIT or ARBITRAGE TRADING.

One of the major reasons for stock prices to move with every single tick of time is because of arbitrage trading. Traders and market makers across the globe keep on continuously buying and selling stocks on one or two exchanges, attempting to get the benefit of price difference. This leads to price change and very high level of volatility in prices of stocks that are traded heavily.

So at the end of the day, if you see a volume of 10 million shares of Reliance stock being traded, then it is possible that a single trader may have bought 1 million shares on NSE and immediately sold them on BSE for a better price – causing a total of 2 million shares to be traded. However, he is having ZERO position at the end.

Interestingly, though traders and market makers across the globe keep on attempting to go for arbitrage trading, they sometimes fail miserably.

The risks involved in Arbitrage trading is no less. One has to simultaneously BUY and SELL.
What if your BUY order gets executed, and your SELL order does not? You end up sitting on a very big number of shares.
Then, what if your SELL order gets executed, but the BUY order does not? At the end of the day, you will be forced to close your position by buying at a higher price – which will result in a big loss.
What if your BUY order for 100 shares was executed, but the SELL order was executed only for 50 shares?

Continue to Part II: How to beat risk in Arbitrage Trading?