Kwang Soo Lee opened the door to receive a package.
The postman handed him his package and asked for a signature.
On the package was written the name “Maggie Lee”.
It was an international shipment.
After receiving the package and signing, Kwang told the postman that the correct name was actually “Maggie Kim”.
The postman was not a postman but an undercover inspector.
Later in the day, he and his team returned to Kwang’s house with a search warrant.
They found many cartons of illegal material in his house.
He was arrested.
At the JFK Airport, another man was arrested for carrying many cartons of illegal material.
Many packages and passengers entering the USA from airports like JFK Airport kept getting arrested for carrying cartons of illegal material.
These people and packages were coming from countries like South Korea, Uzbekistan, China, and a few others.
The arrests were part of an exercise called ‘Operation Smokeout’.
The illegal material? Cigarettes.
What’s wrong with cigarettes? Are they illegal in the USA? Or were these cigarettes different from regular cigarettes?
Cigarettes are legal in the USA. And these cigarettes were not different — they were regular cigarettes.
Still, these cartons of cigarettes led to arrests because — tax.
Cigarettes are taxed heavily in the US. This leads to their prices being extremely high compared to some other countries.
Some smugglers decided to take advantage of this situation.
Buy cigarettes from cheaper sources — China, Uzbekistan, etc. Sell them at expensive locations — the US.
They were avoiding taxes. That’s what made cigarettes illegal.
This happens all across the world.
Gold is often smuggled into India. Fuel is smuggled into Venezuela. Currencies are smuggled into countries suffering from hyperinflation.
Electronics are smuggled. Cars are smuggled.
The price difference exists because of taxes.
But in each case, smugglers are trying to take advantage of a price difference.
Buy low. Sell high. Fast.
This is called arbitrage investing.
Buy low – sell high. That’s what all of investing is about.
How is arbitrage investing different?
Arbitrage investing is all about spotting price differences.
While the above examples are all illegal, there are many perfectly legal ways of buying low and selling high.
When you buy a stock, you might be predicting that its price will go up in the future.
You believe the company is a good company.
That’s not arbitrage investing.
If you saw that stock available for two different prices – and tried to buy cheap and sell expensive – that’s arbitrage investing.
Regardless of how good or bad the company is.
It’s about price differences. Not about the asset itself.
Arbitrage Investing
The world of arbitrage investing is quite vast.
There are many arbitrage investing strategies.
But most of them involve the following steps.
- Find an asset that is priced differently in two markets
- Calculate the profit vs costs
- Buy (where cheaper) and sell (where most expensive)
- Ensure this happens fast enough to avoid price changes
There are many risks associated with this style of investing.
What if it takes too long to buy and then sell – and in that time, the price itself has changed too much?
What if you are unable to buy or sell at all?
These are very real risks in arbitrage trading.
This is why arbitrage trading has become an area dominated by extremely skilled and well-equipped investors.
High-Frequency Traders (HFTs) are one example. HFTs have supercomputers that place and execute trades in milliseconds.
Because these trades happen so fast, the window of opportunity is incredibly small.
Think of it like this: buying and selling influence prices.
Say,
1 kg rice costs Rs 40 in New Delhi
1 kg rice costs Rs 45 in Mumbai
This means, there is an arbitrage opportunity. You can buy it in New Delhi and sell it in Mumbai – profit of Rs 5 per kg.
But, because you are buying in New Delhi, demand is increasing. Because of that, the price of rice will start increasing in New Delhi.
The price will climb from Rs 40 to Rs 41, then Rs 42…
At the same time, because you are selling in Mumbai, the supply there is increasing. So, the price of rice will start falling there.
The price will go down from Rs 45 to Rs 44, then Rs 43…
This is how the price of rice will become the same in both cities.
Now, this means that till the prices of rice in both cities are different, you can buy and sell – and make a profit.
There exists an arbitrage opportunity.
But, once the price is the same in both cities, it does not make sense anymore.
Now, imagine that this fact is not just known by you. Many others also know this – and are trying to take advantage of it.
The higher the number of people trying to do this, the shorter the window of opportunity – the faster the prices will become the same in both cities.
In a crude manner, this is what happens in the share markets.
In fact, arbitrage trading happens not only in the share markets, but also in the bond markets, currency markets, commodity markets, and so on.
Most of them – at lightning speed.
Arbitrage Funds
There are some mutual funds that use this strategy.
They are called arbitrage funds.
What do they do?
They look for arbitrage opportunities in the cash and futures markets.
So, let’s say, a share’s price is Rs 50 in the cash market and Rs 51 in the futures markets.
They will buy from the cash market and sell in the futures market. The profit here is Rs 1 per share.
Arbitrage funds are deemed extremely low-risk, even though they invest only in shares.
There are multiple reasons for this.
Because arbitrage funds depend on price differences – and not exactly the overall market direction – they work even when share prices are going down.
In fact, they tend to do better when the markets are volatile.
Because their entire strategy is to spot price differences, they do not hold a stock for very long. This way, they are not exposed to the risk of the company’s performance.
When there are not enough arbitrage opportunities, they park their money in extremely safe assets like government bonds, low-risk debt, etc.
On the other hand, their returns are not very high.
They are stable returns, but not high – comparable to liquid funds and other debt funds.
Investors
Arbitrage funds play it safe.
But that does not mean all arbitrage strategies are low-risk low-returns.
There are many arbitrage strategies that are extremely risky – but can give astounding returns.
Often, these must be practiced by skilled and knowledgeable people only.
If you’re interested in learning more, read about statistical arbitrage, convertible arbitrage, triangular arbitrage, and covered interest arbitrage.
There are many more.
The images above were generated using AI tools.
Quick Takes
+Bank of Japan raised its key lending rate to 0.50% from a previous rate of 0.25%.
+Japan’s annual inflation rose to 3.6% in Dec 2024 (vs 2.9% in Nov). Core inflation (excludes food prices) rose to 3% (vs 2.7% in Nov).
+Tata Electronics acquired a 60% stake in Pegatron’s Indian subsdiary, an electronics manufacturing firm. The firm manufactures iPhones at its Chennai facility.
+India’s forex reserves fell by $1.8 billion to $624 billion in the week that ended on 17 January.
+EPFO added a net of 14.63 lakh members in Nov 2024 (a year-on-year rise of 4.88%). Of this, 8.74 lakh were new members, a year-on-year rise of 18.80%.
+Reliance Jio added 12 lakh wireless subscribers to its network in Nov. Airtel lost around 11 lakh, Vodafone-Idea (Vi) lost 15 lakh, and BSNL lost around 3 lakh: TRAI.
+The number of unique registered investors on NSE crossed 11 crore on 20 Jan. The total number of accounts on the NSE: 21+ crore (investors can have multiple trading accounts).
+Hindustan Unilever will acquire a 90.5% stake in the beauty products brand Minimalist for around Rs 2,700 crore by the April-June 2025 quarter.
+The US passed an order to withdraw its membership from the World Health Organization (WHO).
+UK's unemployment rate rose to 4.4% in November (vs 4.3% in October).
+Donald Trump was sworn in as the 47th US President.
+The third round of Production-Linked Incentive Scheme will have 24 beneficiaries, with investment of Rs 3,516 crore. It is aimed at boosting the production of air conditioners and LED light components.
+The National Company Law Tribunal (NCLT) has ordered the liquidation of Go First Airways.
6-Day-Course
Theme of the week: themes affecting the stock markets
We’ve reached the end of this week’s course that started on Monday. Here’s a test you should take. Get pen and paper!
Question 1:
If the US is having a trade war with China, the stock markets globally will be ____________, compared to when both nations have a good trading relation.
-Positively affected
-Negatively affected
-Not be affected
Question 2:
Any change in crude oil prices has no effect on the domestic stock market.
-True
-False
Question 3:
Which corporate event can directly impact stock prices?
-Share buybacks
-More hiring
-Office relocation
Question 4:
Huge amounts of investment from institutional investors cannot affect a foreign country’s stock market.
-True
-False
Question 5:
Which factor can have a long-term impact on the economy?
-Income tax changes
-Daily stock fluctuations
-A longer monsoon
Answers:
Q1: Negatively affected
Q2: False
Q3: Share buybacks
Q4: False
Q5: Income tax changes
The information contained in this Groww Digest is purely for knowledge. This Groww Digest does not contain any recommendations or advice.
Team Groww Digest