Arbitrage, in layman’s terms, involves simultaneously buying and selling the same asset across two different markets, profiting from the price difference. Many times, arbitrage is considered to be risk-free as the two simultaneous acts automatically hedge the price risk of the asset going up or down in value. Let’s take an example. Suppose Reliance Industries’ shares are trading at ₹860 on the BSE and at ₹862 on the NSE. One could simply purchase the shares at ₹860 from the BSE and sell the same quantity at ₹862 on the NSE.

In most equity markets, the trader can immediately claim a profit of ₹2; however, since cross-clearing has not been approved in India, the trader would need to sell the BSE shares and purchase back the NSE shares within the same day to capture the ₹2 profit.

Due to arbitrage, the prices tend to converge andthe price of Reliance shares may overlap on both the exchanges. At that point, the trader can execute his reversal trades. For example, assume Reliance Industries is priced at ₹865 later in the same day.

Cash-Futures arbitrage The trader would sell his shares at ₹865 on the BSE and purchase shares at the same price on the NSE. He has now earned ₹2 in profit per share. Another common arbitrage strategy is the Cash-Futures arbitrage.

Suppose Reliance Industries equity is trading at ₹860 on the NSE, and the near month Futures contract is trading at ₹870 on the NSE. The trader can buy the underlying and sell the Futures contract.

Since Futures contracts are traded in lots, the trader should execute the same number of shares. Since Reliance Industries has a lot size of 250, the trader could purchase 250 shares of Reliance Industries at ₹860 and sell one lot of Reliance Futures at ₹870.

Now, the trader has two options. As the price difference between the Futures price and the Equities price is ₹10, he needs to wait for the price difference to be lower than ₹10 to earn a profit. If this is not possible, he can hold the positions overnight and execute the reverse trades on a future date.

The risk here is that the Securities Transaction Tax for delivery shares (holding shares overnight) is significantly higher than that on sale of shares within the same day (known as intraday). So, it’s best to wait for the price difference to be below ₹10 within the same day.

Patience pays Suppose, later in the day, Reliance shares are trading at ₹864 and Reliance Futures, at ₹872. He sells his 250 shares and buys one lot of Reliance Futures. He has now earned ₹2 in profit.

There are many profitable arbitrage traders who use automated algorithms that constantly scan the markets for price discrepancies. If you’re looking to play the arbitrage game, be patient and seek out opportunities where the price discrepancy is large. Over time, you can look to increase your position sizes.

(The writer is the co-founder of www.rksv.in)

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