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Arbitrage in Commodities

In the financial market, varied trading strategies can be employed depending upon one’s appetite for risk, investment capacity, time frame etc. One can go for outright purchase/sale, long term investment, hedge or arbitrage. At times of high volatility, one of the safe ways to minimize risk and maximize profits is through arbitrage.

Basically, arbitrage involves simultaneous buying and selling of an asset in order to profit from the difference in price. A person who attempts to make profit from employing such trading strategies is called arbitraguer.

Arbitrage opportunity exists in a market due to perceived or real difference in the prices from the equilibrium price as determined by the supply and demand. The difference is said to exist because of pricing inefficiencies.

Any of the below mentioned three conditions are necessary for arbitrage opportunity to arise:

  • The given asset should trade at different prices in all the markets
  • Two assets with identical cash-flows should trade at different prices
  • An asset with a known price in the future, must trade today at a different price than its future price discounted at the risk-free interest or cost of carrying as in the case of commodities. As a result of arbitrage, price of an asset tends to converge and the speed with which it happens so reflects the efficiency of that market.

In commodities market, arbitrage opportunities are immense. Traders can capitalize on price discrepancies arising between/in:

  • Spot and futures market of the same commodity
  • Different futures contracts of same commodity
  • Same commodity on different exchange ie inter-exchange; or
  • Similar commodities on same or different exchange ie inter-commodity

While arbitrage trade is visibly risk free and may have the potential to generate better returns on investment than the traditional investment options, one should be aware that this trading strategy is not completely risk free. Returns are not guaranteed and the ratio of profit/loss may vary from time to time depending upon the market conditions.

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