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What is Arbitrage Trading and How Does it Work

To understand arbitrage meaning, you should know that it is an investment strategy used by traders. Traders, through the means of arbitrage, fix gains by purchasing and selling an identical commodity, security, or currency, spread across different markets. This is a move that permits traders to leverage differing prices of the same asset. For instance, a trader might buy a given asset in one market, and sell it in another market where it yields more value. 

Explaining Arbitrage

Arbitrage entails the action of purchasing an asset in a particular market while, at the same time, selling in another, but at more of a price. As a result, traders and investors profit from the difference, which is temporary, in per share cost. Where stock markets are concerned, arbitrage trading lets traders make use of opportunities to purchase a security at a foreign exchange in which the security’s share price hasn’t yet made an adjustment for the rate of foreign exchange. This is an exploitation of selling before the foreign exchange rate goes into a state of flux, and profit-making would be challenging. Harvesting gains from the differential in the two different markets traded in, the cost of the stock in the foreign exchange becomes devalued compared with the local exchange. To the novice, this may be complicated, but understanding what is arbitrage is quite simple and considered low-risk. 

An Illustrated Example 

A clear and straightforward example can illustrate what is arbitrage trading. A bank may trade on two stock exchanges, the Stock Exchange of Toronto or TSX and the New York Stock Exchange or NYSE. On any given day, assume that the security’s trade value is $65.00CAD on the TSX and $50.00USD on NYSE. Further, you can assume that the rate of exchange of USD to CAD is $1.37, where $1USD equals $1.37CAD, so $50USD equals $68.50CAD. You can see that traders make a cool profit by purchasing shares in CAD and selling them on NYSE. 

Transaction Costs

Traders who consider opportunities presented by arbitrage should take transaction fees  into account. Costs may be high and kept as such to limit trade. In case these costs are high, charged per share transacted, they may make profit redundant. To know what is arbitrage in the stock market, you will have to execute trades across markets and learn about price discrepancies too. An important aspect about executing arbitrage as a strategy is that price discrepancies are generally low across markets. Arbitrage can only work to a substantial degree if investors have a significant amount to invest in just a single trade. 

Arbitrage in India

How does arbitrage work in India if securities are not permitted to be bought and sold on the same day through Indian stock exchanges? Well, if you already hold shares in a DP in a free demat account, you can sell them on one exchange and buy the same shares on another exchange. So, if you sell at a higher price and buy identical shares at a lower price, you stand to make gains. 

Related Articles: How to Open a Demat Account Without a Broker | Factors to Keep in Mind While Opening a Demat account | Factors to Consider When Opening a Demat Account | 10 Points to Remember When Operating your Demat Account 


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