Want to earn high returns from the stock market without taking the risk
Is this really possible that you can earn high returns from the stock without actually taking any risk? Well this principle is actually called arbitrage and this strategy does for work for many people. No wonder that there are a number of fund houses that have actually launched many fund schemes known as “arbitrage funds”. Advertised as risk free, apparently there is no likelihood that a person will suffer losses when investing in the stock market.
What is arbitrage?
Simply said arbitrage is actually a principle wherein there is simultaneous buying and selling of the funds or such securities from at least 2 different financial markets. The profit is derived from the differences in the price variations of the same securities in two different financial markets.
The part that is risk free for this strategy is that the buy and the sell contract is executed perfectly so that they balance out each other. For this reason it makes them impervious to the way that the market swings in any direction. Actually there are a number of types of arbitrage strategies. Many of them these strategies may not be risk for you. In India one of most commonly used arbitrage strategies is to buy and sell in the future.
Of course this is following on the assumption when the price of the stocks in the cash market is far lower than selling in the futures market. This is the usual case when the price in the cash market is lower than in the futures market.
This difference in the prices between the cash segment and the futures segment helps the investor in making the profits in the markets. The futures contracts will expire on the last Thursday of each month. As the expiry of the positions gets closer, the difference reduces and the investors are able to mark their profits.
Let’s take an example to make this clear. For example if a stock is selling for Rs 300 and the futures contract is for Rs 375, it means that an investor has already locked in a profit of Rs 75. When the future contract is expired, the price rises to Rs 400. Now when the position is finally unwound, the trader buys the futures contract at Rs 375 locking in a profit of Rs 25 (400-375). Since the futures contracts are always traded in lots and lets say that the trader had 200 shares, the trader has made Rs 5000 (200X25).
Essentially this is the kind of strategy that is followed by the arbitrage funds to generate profits for their clients. However if were all to do this, it would mean that all of us can become millionaires overnight.
However there are certain conditions that restrict all of us from becoming millionaires overnight. There are certain risks and restrictions that are currently deployed in the market.
Lesser number of funds is available in the derivatives market
Dealing in arbitrage funds would mean that you need a higher number of stocks that are available in the arbitrage market. Currently there are a few stocks that can be bought and sold on the derivatives market. This decreases your chances of playing all out in this market. In a number of cases and especially when the market is undergoing a downturn, the price of the derivative stock is far lower than the cash segment. This beats the whole strategy of booking the profits through the arbitrage funds.
In fact certain funds even have the option of investing in stocks if they find that few or no profit making arbitrage chances exist. For this reason, this completely nullifies the reason for the investor to invest in these funds. Also the past performance of the fund is really no indicative that it would also invest in the arbitrage market in the future also.
The price condition may not be met totally
When the futures contracts expire, sometime, the price may not be the same as was indicated on the futures. It may even differ slightly. In those cases the profit booking in the arbitrage funds can be lower also. Investors should realise that arbitrage funds can generate high profits as well as lower profits or profits that were lower than that expected by the investors.
Futures is always traded in lots
Futures are traded in lots, which means that the fund manager would require buying a number of shares of the same company. Quite simply, this means that the fund manager may not have the money at a particular time to buy the lots at a particular price. For this reason, liquidity has a great deal to play in the arbitrage funds. Deep pockets and high liquidity is important for the funds and the investors.
Sometimes it can become difficult for a fund manager to buy all lots or say 3 lots of the futures contract at the same price. Usually the futures contracts are squared off on the date of their expiry.
Sometimes the stocks that have been bought through the arbitrage strategy may also be sold off before the expiry date of the futures contract. At other times, if the liquidity of the fund is really low, the stocks may even remain unsold. This means that the profit booking may not take place. If this happens then kit can greatly affect the performance of the fund. Sometimes it can bring the profits of the whole fund down considerably.
In most cases, the arbitrage funds are considered to be risk free than the other funds that are diversified and invest in debt and equity. But as can be seen, the arbitrage funds are not without their risk also. Its time to understand that all investments have some amount of risk attached with them. You should be ready to take the risks or understand the risks attached to them. If you are unable to take these risks or can’t understand the risks, then you should stick to investing in the diversified funds that are available.