Financial markets run on the principle of the Law of One Price- all identical financial instruments with similar characteristics, should trade at one price. If there is any mispricing, it can be eliminated by the participants using arbitrage opportunity.
Arbitrage means when two identical financial instruments with similar characteristics, trade at two different prices in the financial market at the same time. Let’s simplify it- Two apples with the same quality trades at Rs100 per kg at the local fruitwala and at Rs 110 per kg at ABC grocery store. If you apply the basic concept of “Buy Low Sell High”- you would buy it at Rs 100 kg from the Fruitwala and sell it to ABC grocery store for 110 per kg (at the same time). This will provide you Rs 10 profit without even worrying about any risk i.e. riskless profit. Eventually if enough people buy from the fruitwala, he may increase his price to Rs 105 while if enough people keep selling to ABC grocery store then eventually they will reduce their buying price from Rs 110 to Rs 105. SO the price difference will slowly disappear. When the prices at the Fruitwala and ABC grocery store match up, then it won’t matter which store we buy from or sell to as they will have the same prices!
Such situations of mispricing arise in the financial market but are often short-lived. For example, the share price of Stock A trades at Rs 50 in BSE, but the same stock trades at Rs 47 at NSE. Simultaneous purchase and sale of stock by a trader will result in a riskless arbitrage profit of Rs 3. But this price difference disappears in a matter of seconds (due to the same reasons as above — people take advantage of this arbitrage which eventually makes the price at BSE=price at NSE).
As retail investors, we may be able to spot some arbitrage opportunities. We may try to exploit these by trading manually, but the opportunity is gone before we know it! This is because many big traders have automated software to spot such arbitrages and execute those trades. They get there before we can! Financial markets try to eliminate this price inefficiency in the form of high trading costs, which essentially makes the opportunity to exploit these differences in price into an unprofitable one!
Credits: Shivangi Bhatia
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