Definition: Arbitrage is the process of simultaneous buying and selling of an asset from different platforms, exchanges or locations to cash in on the price difference (usually small in percentage terms). While getting into an arbitrage trade, the quantity of the underlying asset bought and sold should be the same. Only the price difference is captured as the net pay-off from the trade. The pay-off should be large enough to cover the costs involved in executing the trades (i.e. transaction costs). Else, it won’t make sense for the trader to initiate the trade in the first place.

Description: Suppose an asset, gold, is quoted at Rs 27,000 per 10 gm in the Delhi bullion market and at Rs 27,500 in the Mumbai bullion market. A trader may buy 10 gm of gold in Delhi and sell it in Mumbai, making a profit of Rs 500 (Rs 27,500 - Rs 27,000). However, this trade will be profitable only if the cost of transactions is less than Rs 500 per 10 gm of gold.

In the above example, assuming that the total transaction cost, of executing the trades and physical delivery of gold, is Rs 200 for 10gm, then the net profit for the trader would reduce to Rs 300.

If the price difference between the two bullion markets reduces to Rs 200 (or less than that) per 10gm of gold, then the arbitrage opportunity between the two markets shall cease to exist, as the transaction costs shall be equal to, or more than, the price difference between the two markets.

In real life, arbitrage opportunities (if any) exist only for brief periods since most of the arbitrage trading has been taken over by algorithm-based trading in matured markets. These algorithms are quick to spot and capture arbitrage opportunity, making it easy for human traders to keep track.