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What is the locational arbitrage trading strategy?

Locational arbitrage is a strategy that exploits price discrepancies across different markets or locations

Arbitrage is a trading strategy where you buy one asset in one market and immediately sell that asset in a different market for a slightly higher price. In slightly more technical terms, you identify the same asset that is being traded in two markets at two points, and you short the expensive one and buy the cheap one.

In this article, we’re going to explore a specific type of arbitrage called the locational arbitrage strategy.

Understanding locational arbitrage

Locational arbitrage hinges on the principle of buying assets at a lower price in one location and simultaneously selling them at a higher price in another location, pocketing the difference as profit.

Most often, since the asset traded in both markets is the same and the trade occurs in just fractions of a second, this profit generated is also called a risk-free profit.

Locational arbitrage can be applied to various assets such as:

  • Currencies: Exploiting exchange rate differentials between banks or money changers.
  • Stocks: Capitalising on price discrepancies between Indian stock exchanges (NSE, BSE) or listing the same stock on a foreign exchange.
  • Commodities: Taking advantage of price variations for physical commodities like gold or agricultural products across different markets.

Why do such arbitrage opportunities exist?

You could be wondering why the same asset is valued differently from one market to another – and you’d be asking a very good question.

The answer is that the entire currency, or commodity market is not centralised globally. While stock more or less is, currency and commodity markets span entire continents at the same time, trading continuously at every market. Several participants like banks, hedge funds, and large corporations try to trade at once, which means that at a specific time and a specific place, there might be a tiny difference in price for the same asset.

Making a trade

Let’s say there’s an upcoming major festival in India, like Diwali, which typically leads to a surge in gold demand.

You notice a price difference between gold offered by two different vendors:

Vendor A (local jeweller): Selling gold at ₹50,000 per 10 grams.

Vendor B (major online retailer): Offering gold at a discounted price of ₹49,500 per 10 grams due to a pre-festival sale.

This ₹500 per 10 gram difference presents a potential arbitrage opportunity. You can now buy at Vendor B and sell quickly at Vendor A, after factoring in any transaction charges, before the market price of gold adjusts to lock in this profit.

How hard is it to use location arbitrage in India?

While the concept of locational arbitrage seems straightforward, there are some things that make it more complicated:

  • Limited scope for currency arbitrage in India: Strict capital account regulations in India restrict the movement of large amounts of capital for arbitrage purposes. This limits opportunities for large-scale currency arbitrage in the country, especially for retail investors. Institutions like banks usually find a way to go around these provisions.
  • Technology and automation: With advancements in technology, algos, and AI, arbitrage opportunities are fleeting at best. High-frequency trading algorithms can identify and exploit price discrepancies almost instantaneously, leaving minimal windows for manual intervention.
  • Transaction costs: This is probably one of the biggest considerations you have to make when becoming an arbitrageur. Transaction costs, including brokerage fees, currency conversion charges, and taxes, can erode profits, especially at the retail scale.

Frequently Asked Questions

How hard is it to become an arbitrageur as a retail investor?

Strict currency controls and high-frequency trading algorithms make large-scale arbitrage very difficult for retail investors. Rookie investors without sophisticated equipment and expensive algos basically stand no chance. Retail investors are much better off targeting long-term strategies in the stock market.

Where can I find arbitrage opportunities?

While they’re very difficult to find now that algos are so prevalent in every bank and hedge fund, small windows might still exist. Look for inter-bank currency rate variations – slightly better forex rates, especially for high-volume transactions. NSE-BSE price discrepancies might also be explored, but lightning-fast execution is key in these scenarios.

Cross-border listings sound interesting, but complex. What should I know?

We encourage you to proceed with caution. You’ll need:
Deep knowledge of both markets: Understand the companies and the specific exchanges they’re listed on.
Currency considerations: Factor in exchange rate fluctuations and potential conversion costs.
Regulatory knowledge: The two countries you’re considering might have wildly different trading regulatory requirements, which you’ll have to comply with at the same time. Getting a lawyer to advise you with taxes and regulations might be a wise move.

Can I use borrowed money for arbitrage?

You could, but it is generally not recommended. Arbitrage relies on small profit margins. Borrowing costs can quickly eat into your profits and magnify potential losses. Leverage is always best used wisely and sparingly.

Let’s say I find a perfect arbitrage opportunity – how can I be sure it’s legitimate?

While rare, there can be situations where price discrepancies seem too good to be true, and often they are. Here are some red flags:
Unrealistic profit margins: If the arbitrage opportunity promises exceptionally high returns with minimal risk, it’s likely a scam.
Unlicensed brokers or platforms: Only deal with reputable and licensed brokers or trading platforms to avoid fraudulent activities.
Pressure to invest quickly: Legitimate opportunities won’t pressure you into immediate action. Be wary of anyone urging you to invest rapidly.

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