Stock Market

35.

Arbitrage Trading

We live in an age of unbridled capitalism, consumerism and commercialisation. Ever since the liberal economic reforms in the LPG drive (Liberalisation, Privatisation and Globalisation) of 1991 and the reinforcing neo liberal measures in the UPA 1 and 2 regimes, we have seen the gradual rise of market forces on the nominal socialist economy of our country. Despite several stocks scams and ghapalas, stocks share trading is on the rise, mainly among the Indian middle and upper middle class. Even the great economic slowdown and recession following 2008 has not really reigned in the incessant cash flows (black and white) from institutional and private investors and the speculative game; typical of the share market. Newspapers and media publications have been howling about how the sales of Karl Marx’s ‘Das Kapital’ and other Marxist literature have gone up and how the mushrooming of the Occupy Wall Street movement of Zuccotti park has shook the foundations of capitalism in India and around the world. 

However, amidst this entire hullabaloo over the demise of capitalism and its self destructing institutions and institutional practices, robust economies like India have come into their own. Their share markets, despite the marginal upheavals caused by the volatility of the world economy, have largely been stable and have not really seen any dramatic loss of income. However, there still remain several inconsistencies and potential minefields which can have a murderous impact on the stability and income generating capacities of stock markets. 

Arbitrage Trading: Definition and Scope

The term ‘arbitrage trading’ could be misleading to novices in the field of share stocks trading and hence needs to be defined clearly as to bring out its true meaning and implications for the individual investors, the share market and national economy. Arbitrage trading is a phenomena which comes into play when companies and corporate houses make attempts to raise capital by offering stocks for sale on more than one stock exchange markets in a single country (or theoretically in multiple countries). In those share markets which are not perfect in terms of investment value or price updating facilities, there exists a more than fair chance of discrepancies of share value of the same or closely related shares on different stock markets. When, an investor deliberately invests in the shares of a particular company in one stock market and finding it profitable; sells the same in order to buy the same or closely related shares of the same company or group in another stock market, it is called arbitrage trading. In such a situation, the investor; whether a private individual, a bank or an investment firm, attempts to make profit out of the discrepancies or difference in the price of the shares across different stock exchanges in a single country (or theoretically, in a bunch of countries). 

Arbitrage Trading: Practical exemplification

Do not get confused if you do not understand the technical mumbo jumbo regarding arbitrage trading on the internet. To make the readers understand the meaning of the term ‘arbitrage trading’ and to enlighten them on its financial implications, it is necessary to present a practical and relevant example. Let us start with the premise that an investor has 500 shares of Coal India. At a particular point of time during day trading he gets the information that while Coal India is trading at 200 Rs. per share on NSE (National Stock Exchange), it is trading at 250 Rs. per share on BSE (Bombay Stock Exchange). Hence, the investor decides to sell the 500 Coal India shares on the NSE and simultaneously buys back the shares at the BSE. This transaction effectively makes him a profit of – 500*50= 25000. To encapsulate, this is what precisely is arbitrage trading. 

Fortunately or unfortunately, arbitrage trading is fully legal in India and is in fact one of the main drivers behind the volume of trade on BSE and NSE.