Arbitrage trading is a risk free technique of stock trading. The profits are locked at the initiation of the trade and rest is just the waiting period till the contract expiry of the futures contracts.
Trading in stock markets is a risky business. There is a direct relation between risk and reward. The higher the risk you take, the higher is the returns potential. While risk on a trade is always remains there and you can’t completely remove it. However, there is trading strategy which is completely risk less. This is known as Arbitrage trading strategy. There are different types of traders in the markets. Each trader trades according his/her own risk profile and requirement.
These are the traders who simply speculate or anticipate about the moves in prices of a stock or the index based on their technical analysis. This is based on the technical charts. Speculation can be for the rise or fall in the stock prices in near future. So positions are taken in the market accordingly, long position ( buy) or short position ( sell).
These are the traders who take advantage of the price difference between the Futures and Cash price of a stock. Futures and options are the derivatives. They are different from stocks. Derivatives are derived from the underlying securities. In our case, underlying securities are stocks.There are two types of arbitrage trading strategies : Arbitrage Trading and Reverse Arbitrage Trading Strategy.
This is the technique of taking advantage of difference in the prices of Futures value and the Cash value of the same stock. You may have observed that the Futures price is usually greater than the cash price of the stock when the stock is in an uptrend. When Futures price is higher than cash price, it is called Futures are at Premium. Sometimes, the difference between these values is significantly higher which is beneficial to the arbitragers.
Let’s take an Arbitrage example; Assume, for any month’s Futures contract, the Future price of say Infosys stock is trading at ₹ 2160 and the cash price is trading at ₹ 2000. Lot size for the contract is 125. Now what an arbitrager will do that he/she shall buy 125 shares of the stock in cash and simultaneously sell or short a futures contract.
The logic behind the strategy is that on the expiry day of the Futures & Options contracts, the both prices will converge, that is both futures and cash prices start trading at same price. The trader will never go in loss. If stock price falls,the short position in Futures becomes profitable and if stock price rises then cash position turn profitable. So, difference in Futures and cash price 2160-2000=160 has been locked and this is the profit (125*160=20000).
The point to be taken care of here is that the difference in the prices should be significant so that after excluding the transaction and commission charges for the trade, the return on the trade is appreciable ( 5-6% ). Some modern trading software have inbuilt technique to identify the arbitrage opportunities. A vigilant trader can also spot the same with experience.
Reverse Arbitrage Strategy
This is just the opposite of Arbitrage Strategy. Difference here is that you buy one lot of Futures contract and sell the same number of stocks from your Demat holding. Here the Futures price is lower than the cash price. This is called Futures are at discount. Arbitrage strategies are totally risk free source of making money in the stock market unlike speculative trading.