Trading of similar securities in two different markets simultaneously is known as Arbitraging. This happens when there exists a difference in the price of a security between two or more markets. This is an opportunity to make profit by entering in two or more markets by trading the same security. Arbitraging is a financial transaction that has minimum or no risk. The primary cause for variance in price is due to market inefficiencies.

Arbitraging as a trading strategy can be applied to any financial instrument such as stocks, bonds, derivatives, commodities and currency. A person who engages in arbitraging is known as arbitrageur. An arbitrageur can be a bank, brokerage firm or an individual.

Example of Arbitraging

A very simple example would be buying the stock of say company XYZ on NSE for $10 and selling it in BSE for $11. There is positive cash flow of $1. If the stock is bought in high volumes, then the arbitrageur will earn a significant amount of profit.

Arbitraging trading in stocks continues till the price difference is narrowed down. Arbitraging ensures that the prices do not deviate much from their fair value for long periods of time.

It has become increasingly difficult to profit from the price variance in the markets due to technological advancements and the global connectivity. The traders are quick enough to act on price inefficiency and therefore such opportunities do not last long. There are many types of software available in the market that helps in arbitraging. However, the cost of these softwares is very high.

Although arbitrage trading does exist in the real markets and it helps in reducing the volatility in the market. There are often few risks involved like execution risk - if the trade is not executed properly. The other risks could be counterparty risks and liquidity risk where the counterparty fails to make the payment or one does not have enough money to deposit as margin required for trading.