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Monday, April 01, 2019

Different Price for Same Stock in Different Markets? Welcome to the world of Arbitrage !

If you have been in Stock Market for some time, you would have definitely observed this phenomenon, though you may not have attached enough importance to it. But , some of the biggest successes lie in understanding the smallest things well. Understanding such finer aspects of the market gives you a very fine bird's eye view of the phenomenon called as Stocks, and helps you take wiser decisions in the long run.


Different Prices For the same Stock in two different Exchanges?
You must have observed that different Stock exchanges (like BSE and NSE) show different prices for the same stock on the same day at the same time. Easy to ignore? Of course. Because the difference is actually not a very significant one. 
Ah ! Now that is something for ignorance. 
There is an entire industry which thrives on this 'insignificant difference'. We will read about it for sure. But let us get to the fundamentals first. Why does this difference happen at all? If it is the same company, same stock, then why different market prices?

What are Exchanges?
Firstly, let us understand what Bombay Stock Exchange (BSE) and National Stock Exchange (NSE) actually are. They are two different stocks exchanges or markets, dealing with trading of products (shares in this case). These markets, just like any grocery market, deal with common products among them. As a grocery market deals with common products like apples, potato etc, these markets also deal with common products, which are nothing but the shares of the same companies being traded.

What really happens when same products are sold in two different markets?
Do you remember the example of buying and selling of apples in the bestselling book : 'The Autobiography Of A Stock'? In continuity to the same context, let us understand what happens when Apples are bought and sold in two different markets which are physically at two different locations near your home.

You go to one of the markets (say Market A) to buy one Kg apples and you are able to get your hands on good quality apples at Rs. 100 per Kg. At the same time, your friend went to some other market (say Market B) and got the same quality of apples for Rs. 90 per Kg.
Possible?
Of course possible. 
Prices are all driven by supply, demand, negotiations, individual need, mood, trading volumes, perception and so many other factors. And that is the beauty of a market based scenario. It not only ensures healthy competition but also provides convenience to buyers. 

BSE & NSE are two alternate markets which were created for the benefit of traders/investors. Just the same way as with apples, it is possible for the same company stock to trade at different prices in two different markets at the same time, driven by so many factors like sell and buy orders, local sentiments etc. This difference (popularly known as Arbitrage) is essential, and very much required for either of the exchanges. This is all to keep the system fair, transparent and competitive. If there would be another stock exchange in the future, there too the prices of stocks would vary compared to BSE & NSE. Ultimately it is all about choices available in the market place. Remember, there is no such thing as efficient market.

What is Arbitrage?
Now, both you and your friend come back home and happen to discuss the apple prices that you could manage in the respective markets. But a price difference of Rs. 10 does not bother you much. The next week, you again go shopping for apples and get them at the same price of Rs. 100 from Market A in spite of your best negotiations. In fact, most places it was being sold at Rs 110, and you felt happy that you could manage it in the same price of Rs. 100. On the other hand, your friend could manage to get apples at Rs. 80 this time - and that too the same quality ! 
Now, the price difference is becoming bigger, and it will surely start bothering you at some stage. However, being a shrewd businessman, you see this as a wonderful business opportunity. How about buying apples from Market B at Rs. 80 and selling it in Market A at Rs 110 - a neat Rs. 30 per Kg profit? Interesting, isn't it? 
This is exactly what can happen between two stock exchanges also. You can buy a company stock at a lower price from BSE and sell it at a higher price in NSE. And with today's lightening fast technology, all this can happen in a flash of a second. This  simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset is popularly called as 'Arbitrage' - and there is an entire industry which not only survives, but also thrives on this difference in pricing.

What happens when people start taking advantage of Arbitrage?
If there is a significant difference forming between BSE and NSE prices, arbitrageurs jump in and exploit this opportunity. They have multiple algorithm designs to take advantage of the difference between price in both exchanges. These algorithms help them buy shares from the exchange where the price is lower and sell them in the exchange where the price is higher. This takes place in a matter of seconds and the difference between prices is soon brought down to a level where arbitrage is no longer possible. Hence, the price difference of the stock in both exchanges becomes narrower.

What are Arbitrage Funds?
Those little difference in pricing here and there is what leads to the industry of Arbitrage Funds. These are special mutual funds which leverage the market inefficiencies to generate profits for the investors in the intermediate horizon. Price difference of a stock in two different exchanges is one such inefficiency. Their could also be other associated inefficiencies in the market.  
As an example, the Arbitrage funds can also make money from low-risk buy-and-sell opportunities available in the cash and futures market. Their risk profile is similar to that of a debt fund. These funds are tailor-made for investors, who seeks equity exposure, but are wary of risks associated with them. Arbitrage funds become a safe option for the risk-averse individuals to park their surplus money, when there is a persistent fluctuation in the market.

Conclusion
So, the next time you see a price difference in two markets for the same stock, do not be surprised. Rather, be appreciative of the human mind which knows how to leverage system inefficiencies to run an entire industry.

Regards

Manoj Arora

20 comments:

  1. Thank you manojji for that insight

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  2. Thanks Manoj for knowledge share ...Nice article..

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    1. Thanks and cheers buddy. Happy that it helped you

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  3. Great Sir ! Thanks for sharing...:-)

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  4. Excellent. Thanks for new perspective. Never thought like this. There is a phrase - Penny save is penny earn. This will surely help to save that small amount of money in each transaction which we normally tend to ignore but it will make big difference in long run with so many transactions. Thanks once again

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  5. Thank you for the explanation and making it easy to understand.

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  6. Thank you so for the insightful information

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  7. Thank you for the simple explanation!

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  8. Wow! Can’t miss out on your blog. They are so so informative. Thank you so much Manoj sir!!!

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    Replies
    1. Honoured to have readers like you. Thank you for your kind words.

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  9. Never knew about this....it was so good to read this article and thankfully on time... Wouldn't miss the opportunity to exploit this in future....thank you so much for this insight...can we do it like we trade normally through our stock broker?

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    1. Cheers my friend. Yes, of course you can trade. Its a free market.

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