The next time you place an order to buy or sell a stock through your demat account, just pause and take a moment to glance at its price on the two exchanges – the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE). You might be surprised to find that the same stock is trading a few paise cheaper on one exchange than the other at that very moment, though not always. Thanks to the constant play of demand and supply.

The price gap is often so negligible that most investors barely notice it or ignore. For seasoned traders, however, such fleeting price mismatches can hint at something more: perhaps an ‘arbitrage’ opportunity, waiting to be captured. What an ordinary investor brushes past as just another volatile phase of the market, a veteran trader may see as a chance to lock in a small, calculated profit.

What is arbitrage?

To put it simply, the term arbitrage refers to the practice of capturing profit from price gaps, in the same asset (such as a stock) in two different markets or financial instruments. It involves a dual transaction of buying at a lower price and selling at a higher price at nearly the same time, thereby taking advantage of the spread between the prices. Since the trades are executed at nearly the same time, the arbitrage strategy does not rely on market predictions.

Arbitrage funds are a category of hybrid mutual funds that seek to generate returns from these short-lived price differences. Market watchdog Securities and Exchange Board of India (SEBI) classifies arbitrage funds as equity-oriented funds and requires them to maintain at least 65 per cent gross exposure to equities or equity-related securities. The unutilised portions of the portfolio are often invested in short-term debt or money-market instruments to manage liquidity and optimise overall returns.

Instead of attempting to predict the future direction of the market, whether bullish or bearish, arbitrage fund managers try to take advantage of the temporary price spreads in the same asset across markets or across instruments.

Arbitrage fund managers systematically buy a stock in the cash (spot) market at a lower price and sell its corresponding Futures contract in the derivatives market at a higher price. Alternatively, they may exploit small price differences across exchanges by buying a stock on the NSE and selling the same stock on the BSE, or vice versa. By executing numerous such trades, they try to generate relatively steady returns.

Why volatility matters?

Manikandan Chandran, researcher and founder of Wincredible Technologies, says, “When markets are volatile, the likelihood of price mismatches or gaps across exchanges or between the spot and the derivatives markets tends to increase. When prices move in a jiffy, fleeting gaps emerge, creating opportunities for arbitrage trades.” He says that in relatively calm or sideways markets, such differences may be smaller or vanish more quickly, leaving only limited spreads or sometimes none at all.

Though arbitrage funds use hedged positions to reduce reliance on predicting market trends, they are not entirely risk-free. Their returns depend largely on the availability of pricing gaps, which can vary with market conditions and may sometimes be scarce or absent altogether. At times when spreads (price gaps) are narrow or opportunities are scarce, returns may be modest.

Short-term fluctuations may also occur if trades are not executed at the expected prices, if market liquidity is limited, or because of transaction costs. As a result, arbitrage funds are generally not viewed as high-growth strategies but are instead considered to offer relatively stable, moderate returns.

Who can invest?

Arbitrage funds are generally considered suitable for investors seeking relatively stable returns without involving in market predictions.

They are often considered during uncertain or volatile market phases, when pricing gaps may arise more frequently. However, investors aiming for aggressive long-term growth or wealth creation may find these funds less suitable, as the strategy is not designed to deliver high equity-style growth.

Researcher Manikandan says that with most long-running arbitrage funds delivering about 6%-7% annualised returns on an average since inception, the category has historically behaved as a moderate, low-volatility return option rather than a high-growth equity strategy.

“Though FDs or RDs deliver similar returns, arbitrage funds offer a market-linked, more flexible alternative with easier anytime redemption and generally no premature-withdrawal penalties,” says Manikandan.

Markets are rarely perfectly aligned. Prices flicker, spreads appear and disappear, and in those brief moments of imbalance lie quiet possibilities. Arbitrage funds are designed to work within that space.

(The writer is an NISM & CRISIL-certified Wealth Manager and certified in NISM’s Research Analyst module)

Published on March 2, 2026