Arbitrage Trading: Meaning, Types, Examples and How It Works in India

A share can sometimes have two different prices at the same time. It may be available at one price in the cash market and another through its futures contract. Arbitrage trading seeks to earn from that difference.

The idea is easy to follow: buy at the lower price and sell at the higher price. The next step is to check how much of the difference remains after costs and whether both transactions can be completed as planned.

What is arbitrage trading?

Arbitrage trading involves buying an asset in one market and simultaneously selling it in another to benefit from a price difference.

It can also involve related instruments, such as a share and its futures contract. A futures contract creates an obligation to buy or sell an asset at an agreed price on a specified future date.

A trader who uses this approach is called an arbitrageur. Instead of depending only on a share price rising, the trader looks for a difference between two prices that can be used together.

How does arbitrage trading work in India?

Arbitrage trading in India can involve price differences between exchanges or between the cash and futures markets. In a cash-futures trade, a trader buys shares in the cash market and sells futures contracts covering the same quantity of shares. This is called cash-and-carry arbitrage.

The trader aims to earn from the gap between the two prices after costs, as the positions are closed or settled. A futures price being higher than a cash price is not unusual. The difference can reflect financing costs and expected dividends. The trader therefore needs to calculate whether enough remains after costs to make the trade worthwhile.

Source: NSE, Derivatives Advanced Module, covering cost of carry, cash-and-carry arbitrage and cash-futures convergence.

The same share may also have different prices on NSE and BSE. Before acting on that gap, the trader needs to check how both transactions will be completed and settled. Buying on one exchange should not automatically be assumed to fulfil a sale on another.

Source: SEBI’s framework for short selling, reproduced by NSE Clearing, covering securities delivery obligations.

Types of arbitrage trading strategies

Different arbitrage strategies look at different price relationships:

Pure or exchange arbitrage

This involves buying an asset in one market and selling it in another where its price is higher. The price gap needs to cover trading costs, and the required quantity must be available on both sides.

Futures arbitrage

Futures arbitrage looks at the difference between an asset’s cash price and its futures price. In cash-and-carry arbitrage, the trader buys the asset and sells its futures contract. Reverse cash-and-carry uses the opposite positions, where permitted and supported by the necessary borrowing arrangements.

Index arbitrage

Index arbitrage compares an index futures price with the value of the corresponding basket of shares. An index is a calculated value, so it cannot be bought directly. The trader needs a suitable investment representing the underlying shares.

Source: NSE Indices, Nifty 50 Arbitrage Index methodology

Merger or risk arbitrage

Merger arbitrage looks at the difference between a company’s current share price and the value offered in a proposed acquisition. A share may trade below the announced acquisition price while investors wait for the deal to be completed. The result depends on whether the transaction goes ahead on the expected terms.

Convertible arbitrage

A convertible security, such as a convertible debenture, can be converted into shares under specified terms. Convertible arbitrage involves taking a position in that security alongside an offsetting position in the underlying shares. The trader examines how the two are priced relative to each other.

Dividend arbitrage

Dividend arbitrage examines the prices of shares and related derivatives around an expected dividend. Buying a share before its ex-dividend date does not, by itself, create an arbitrage profit. The expected dividend also affects share and derivative prices.

Retail arbitrage

Retail arbitrage means buying products in one marketplace and reselling them at a higher price elsewhere. It is associated with retail and e-commerce rather than securities trading.

Example of arbitrage trading

Suppose a share can be bought for ₹1,000 in the cash market, while its futures contract can be sold at ₹1,010 per share. The starting price gap is ₹10 per share. Here is how costs affect that amount:

The ₹10 gap is the starting spread, not the final profit. This example assumes matched quantities, both trades being completed at the stated prices and the strategy being held through convergence at expiry. It excludes income tax and assumes no dividend or corporate-action adjustment.

The amounts are shown per share to explain the calculation. Actual futures trades follow the applicable contract lot sizes, margins and settlement requirements.

The figures shown are for illustrative purpose only.

Source: NSE, Derivatives Advanced Module

When do arbitrage opportunities arise?

Arbitrage opportunities can arise when prices in different markets do not adjust at exactly the same time. Common reasons include:

• Different demand: Buying or selling activity may be stronger in one market than another.
• Differences in liquidity: The quantities available to buy or sell may vary.
• Information reaching markets at different speeds: Related prices may take slightly different amounts of time to respond.
• Quick price movements: A share and its related contract may briefly move out of line.
• Cash-futures differences: The available spread may exceed trading and financing costs.

These gaps often narrow as traders act on them. Three practical requirements help assess an opportunity: comparable assets or instruments, the ability to complete both transactions close together in time and a positive spread after costs.

Tools and platforms for arbitrage trading

Traders use market data and trading tools to compare prices and keep track of both transactions. Useful tools include:

• Stockbroking platforms: Platforms offered by SEBI-registered stockbrokers provide access to recognised exchanges and trading segments.
• Real-time market data: Price feeds and order books show buying prices, selling prices and available quantities.
• Analytical tools: Software can help compare cash and futures prices, contract details and trading costs.
• Algorithmic trading systems: Automated systems may monitor price differences and place orders using predefined rules.

An arbitrage trading platform should make it easy to check order status, both positions and the money required to maintain them. Automated trading arrangements must follow applicable SEBI and exchange requirements.

Source: SEBI, Safer participation of retail investors in algorithmic trading.

Step-by-step arbitrage trading process

The basic process is:

1. Compare prices: Monitor the same asset or related instruments across the relevant markets.
2. Check the available trade: Look at the prices and quantities at which buying and selling can actually take place.
3. Calculate costs: Work out how much of the spread remains after charges and financing expenses.
4. Check the funds required: Account for the purchase amount, margins and settlement payments.
5. Place matched orders: Aim to complete both transactions as close together as possible.
6. Track and complete the positions: Follow the planned exit or settlement.

Some opportunities are brief, but that does not mean every arbitrage trade ends immediately. Cash-futures positions may remain open until expiry.

Advantages of arbitrage trading

When positions are appropriately matched, arbitrage offers these features:

• Less dependence on market direction: The strategy focuses on a price relationship rather than only on whether prices rise or fall.
• A starting spread that can be assessed: Traders can compare available prices and calculate the associated costs before trading.
• Support for market efficiency: Buying and selling activity can help bring related prices closer together.
• A professionally managed route: Arbitrage mutual funds allow investors to participate without managing individual trades themselves.

These features vary by strategy. Merger arbitrage depends on a deal being completed, while statistical arbitrage relies on pricing relationships behaving as expected.

Risks and challenges of arbitrage trading

A price gap is worth examining, but a few practical factors can change the result:

• Prices may move: The available price can change before both transactions are completed.
• An order may be partly filled: The required quantity may not be available at the displayed price.
• Costs can absorb the spread: Trading and financing expenses may leave little or nothing from the initial gap.
• Funds may be needed during the trade: Futures positions can involve daily settlement payments.
• Systems and assumptions matter: Data interruptions or changes in the expected price relationship can affect the trade.

Futures positions are marked to market daily, meaning gains and losses are settled during the holding period. Traders therefore need to plan their cash requirements even when the two positions are matched.

Source: NSE, Equity derivatives settlement mechanism.

How to improve arbitrage trading efficiency

Start with the prices available for an actual transaction, rather than only the last traded prices displayed on a screen.

Check how much can be bought and sold at those prices. A larger order may be completed across several price levels, changing the final calculation. NSE describes this effect through impact cost, which depends on the transaction size and available orders.

Calculate costs before placing orders and monitor both transactions together. It also helps to have a plan for managing the position if one order is completed before the other.

Source: NSE, Impact cost

How arbitrage mutual funds work

Arbitrage mutual funds pool money from multiple investors and invest it collectively. Investors receive units based on their investment and the scheme’s applicable net asset value, or NAV.

The fund manager uses the pooled money to seek returns from price differences between the cash and futures markets.

These funds typically buy shares in the cash market and sell futures contracts on the same shares. The difference between the buying and selling prices is the starting spread before costs.

The portfolio may also include debt and money market instruments within the scheme’s permitted allocation. Investors hold fund units, while the fund manager handles the underlying transactions.

Source: SEBI Investor, Arbitrage mutual funds, explaining the cash-futures approach.

Arbitrage funds generally receive equity-oriented tax treatment when they meet the applicable legal conditions. Their returns are not fixed, and their NAV can fluctuate. Tax treatment depends on the relevant provisions and the holding period.

Source: Income Tax Department, Capital gains on shares and equity-oriented fund units.

The tax information in this article is based on prevailing laws at the time of publishing the article and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.

Explore arbitrage investing with Bajaj Finserv Arbitrage Fund

You don’t have to track price differences or place individual trades yourself to invest through an arbitrage strategy. Bajaj Finserv Arbitrage Fund brings this approach to you through a professionally managed mutual fund.

The fund seeks returns from price differences between the cash and derivatives segments of equity markets, with the balance invested in debt and money market instruments. The fund manager handles the underlying transactions, while you invest through fund units.

You can choose from Direct and Regular plans, with Growth and Income Distribution cum Capital Withdrawal, or IDCW, options. Growth keeps earnings invested within the scheme, while IDCW provides distributions when declared.

Explore the fund on Bajaj AMC’s website, review its features and costs, and choose the plan and option that fit your needs. Once your KYC requirements are complete, you can invest through Bajaj AMC’s online investment facility. Returns remain subject to market movements and are not assured.

Sources: Bajaj Finserv Arbitrage Fund, official scheme page; Bajaj AMC, investment plans and options.

Conclusion

Arbitrage trading is about finding a price difference that remains worthwhile after costs. Understanding how the two transactions fit together is just as important as spotting arbitrage opportunities.

Investors can explore direct arbitrage trading or consider arbitrage mutual funds for professional management. The choice depends on their knowledge, available time, investment needs and comfort with changes in value.

FAQs

How much money is needed to start arbitrage trading?

There is no single starting amount for every strategy. It depends on the asset price, trade size, contract lot size, margins and costs. Cash-futures trading also requires money for the cash purchase and settlement payments.

Is arbitrage trading legal in India?

Arbitrage trading can be carried out within India’s regulated securities markets, subject to applicable SEBI, exchange and settlement requirements. Where a transaction involves short selling, the trader must meet the prescribed delivery obligations.

Do I need a special licence to trade arbitrage in India?

An individual trading in their own account does not need a separate arbitrage-specific licence. They must use a SEBI-registered stockbroker and meet the requirements of the relevant trading segment. Automated arrangements have additional applicable requirements.

What is statistical arbitrage?

Statistical arbitrage uses statistical models to identify pricing differences between securities. Traders study historical relationships and market data to find situations where prices appear to have moved out of line. The approach depends on those relationships behaving as expected. Past patterns do not ensure the same result in future trades.

How do high-frequency traders use arbitrage?

High-frequency traders use automated systems and fast trading infrastructure to identify and act on short-lived price differences. They may complete a large number of transactions, seeking small gains from each trade.