Commodity Arbitrage - Types & Strategies in India

If you have ever been shopping in a tourist destination, you might have noticed several shops selling the same products. However, some shops might sell a product at a higher price while some might sell it at a lower price. Imagine taking advantage of this price difference by purchasing the cheaper product and selling it at a higher price. This is known as arbitrage.

Arbitrage refers to the process of benefiting from the pricing discrepancies of an asset in different markets. An arbitrage strategy involves purchasing from an undervalued market and selling in an overvalued market. In this blog, we will explore commodity arbitrage in greater detail and understand the various types of arbitrage.

What is Commodity Arbitrage?

The commodity market plays a significant role in facilitating the trade of several commodities. The commodity market connects buyers and sellers across the world supporting global trade. As a result, it also presents arbitrage opportunities to traders.

Commodity arbitrage is a trading strategy in which traders benefit from the difference in prices of the same commodity in different markets. The strategy involves buying a commodity in a market where the price is lower and selling the same commodity in the market where its price is higher. This allows the traders to pocket the difference and earn a profit.

A commodity may have different prices at the same time due to several reasons such as the geographical location of the market, demand, or time differences.

Even an exchange’s inefficiencies in price discovery can lead to a difference in price. For example, the price of a commodity may be different on the Multi-Commodity Exchange (MCX) and the National Commodity and Derivatives Exchange (NCDEX) at the same time.

Types of Commodity Arbitrage

Traders can find arbitrage opportunities in several ways. Let’s take a look at the different types of commodity arbitrage.

Spatial Arbitrage

Spatial arbitrage refers to the discrepancies in a commodity's price in geographically separated markets. A trader can purchase a commodity in a region where the price is low and sell the same commodity in a region where the price is high.

Temporal Arbitrage

Time can also be used for arbitrage. Temporal arbitrage involves profiting from the price differences of a commodity at different points in time. A trader can purchase a product when it’s trading at a lower price and then sell it at a higher price in the future.

Inter-Exchange Arbitrage

As we discussed earlier, there might be inefficiencies in pricing a commodity between two exchanges. This allows traders to execute arbitrage trades by purchasing the commodity for cheap in one exchange and selling it for a higher price in another exchange.

Cash and Carry Arbitrage

The cash and carry arbitrage strategy exploits the price discrepancies between the spot market and the futures market. While trading commodities, a trader can purchase the commodity from the spot market and short the futures contract of the commodity. This type of arbitrage works only if the futures of the commodity are more expensive than the spot price.

Statistical Arbitrage

Statistical arbitrage is a more advanced method of arbitrage. It makes use of highly sophisticated financial and statistical models to profit from price differences in co-related assets and financial instruments.

How Does Commodity Arbitrage Work: A Step-by-Step Guide

Commodity arbitrage is a strategy that benefits from the price differences of one commodity in different markets.

Step 1: Identify a commodity that you want to trade

Step 2: Noting the price of the commodity in different markets

Step 3: Purchase the commodity from the market where it is trading at a lower price

Step 4: Simultaneously or sequentially, sell the commodity in the market where it is trading at a higher price.

Step 5: The price difference between the two markets is the gross profit.

For example, crude oil is trading at $50 per barrel in country A and $55 per barrel in country B. A trader can purchase crude oil from country A and sell it in country B. The trader will earn a gross profit of $5. However, he might have to incur costs of transportation, storage, and transaction costs.

Benefits of Commodity Arbitrage

There are several key benefits of commodity arbitrage. which include:

Low-risk

Arbitrage trades are theoretically risk-free since these trades profit from price differences by buying and selling commodities simultaneously across markets.

Non-Speculative

Arbitrage trading does not require any prediction about the price direction. Arbitrage aims to exploit the price discrepancy and not speculate on the price movement.

Exploits Market Inefficiencies

Traders can benefit from arbitrage trading as it exploits market inefficiencies. As a result, there are several opportunities for arbitrage trading.

Risks & Challenges

Although arbitrage trading is risk-free in theory, there are several challenges associated with it.

Execution Risk

The price of commodities changes frequently and might change before both legs of an arbitrage trade are executed.

Associated Costs

Arbitrage trading can often be expensive as there are several associated costs like transaction charges, taxes, and transportation & storage costs.

Regulatory Compliance

Traders need to be aware of the various regulations of commodity arbitrage. A trader should ensure that the arbitrage strategy meets the regulatory compliance to avoid any fines or penalties.

Slippage and Latency

Arbitrage requires snappy and quick execution. If there is a lag in the system or any technical issue, a trade might not execute as planned, or the price might change. This leads to slippages and additional costs.

Arbitrage Opportunities in the Indian Commodity Markets

Commodity traders can find arbitrage opportunities in Indian markets in the following ways:

• Pricing differences between exchanges like MCX and NCDEX.
• If available, arbitrage between Indian and global markets can be done through a contract for difference (CFD).
• Traders can benefit from the price differences of agri commodities like soybean and cotton across exchanges and mandi markets.

Conclusion

Arbitrage trading in commodities can prove to be highly beneficial and effective to exploit market inefficiencies. However, it is important for traders to be aware of the challenges and associated costs while entering into arbitrage trades. Moreover, it is crucial to have executional prowess to make the most out of arbitrage trading.