Arbitrage is an investment strategy which is used to take advantage of the price differential between two or more markets to earn a profit. This activity of buying and selling the same security can happen on different exchanges or between spot prices of a security and its future contract.
Exchange to Exchange arbitrage : You buy in one exchange and sell in another. Cross selling across exchanges is not allowed in Indian markets, so you have to reverse the position before end of day as trade needs to be squared off on the same exchange.
Arbitrage is not totally risk free when you are doing arbitrage between two exchanges. If you have delivery position in a stock, you can execute risk-free arbitrage (i.e. you can give delivery in one exchange and take delivery from another exchange).
Cash-Futures arbitrage: Since futures are traded in lots, a trader should execute the same number of shares. For example, one can buy shares of a company in the cash market and sell futures contract of an equal number of shares. The price differential is arbitrage. The price of a stock and the futures contract converges by the end of the expiry , so this offers risk free profit. Here again, this gap can widen in the middle and you may lose if you try to square off at that time.
Mostly institutional investors or mutual funds or traders associated with stock brokers take advantage of arbitrage opportunities. They use software that helps them detect and execute such trades fast.
It may be difficult for retail investors to earn big returns using arbitrage. Arbitrage trading has to be very quick and a retail investor, in manual mode, may miss the opportunity in a blink. Mutual funds can help those who want to take the arbitrage route but lack expertise. Most arbitrage funds require a minimum investment of Rs.5,000. According to Value Research, arbitrage funds category has given a return of 6.82% in the last one year.
Arbitrage Funds: The definition of an equity fund, for tax treatment purposes, is 65% or more of the portfolio, which is measured as an average of last one year, on the first and last working day of the month. For 65% or more of the portfolio in an arbitrage fund, the fund manager purchases equity stocks and sells the same stock in the futures market. The sale position in the stock futures market is a little higher than the purchase position, which is the fund’s earning. The balance is invested in money market or debt instruments.
These funds are technically equity funds and enjoy the tax efficiency of an equity fund over debt funds. There is no long term capital gains tax for holdings of more than one year, no dividend distribution tax and short term capital gains tax for holdings of less than one year is 15% plus surcharge and cess. Arbitrage funds are suitable for fixed income oriented investors. Conservative fixed income investors can look at arbitrage funds for an allocation in the portfolio, since there is no open position in equities as it is completely hedged.