Trading The Odds With Arbitrage

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Trading The Odds With Arbitrage

“I don’t use darts on a board. I make sure bets. Sun Tzu’s The Art of War is a must-read. Every war is won before it begins.” Many of you may have heard Gordon Gekko say these remarks in the film Wall Street. Gekko earns a fortune as an arbitrage pioneer in the film. Unfortunately, not everyone has access to such risk-free trading.

There are, however, various different types of arbitrage that may be employed to increase the chances of completing a successful deal. We’ll look at the notion of arbitrage, how market makers use “real arbitrage,” and how ordinary investors might profit from arbitrage possibilities.

Key Takeaways

  • Arbitrage is the simultaneous buying and selling of an asset in two or more marketplaces in order to benefit from the price difference.
  • Risk arbitrage is a kind of speculation utilized during takeovers that allows an investor to benefit on the difference between the acquirer’s valuation of the target stock and its actual trading price.
  • Market makers have various arbitrage advantages over regular investors, including greater access to trading funds and real-time news.
  • Risk arbitrage by retail investors may be calculated using Benjamin Graham’s risk-arbitrage calculation.

Concepts of Arbitrage

In its purest form, arbitrage is defined as the acquisition of assets on one market for prompt selling on another in order to benefit from a price difference. This leads in a risk-free profit right now.

For example, if a security’s price on the New York Stock Exchange (NYSE) is out of sync with its matching futures contract on the Chicago Board of Trade, a trader might simultaneously sell (short) one and purchase the other, benefitting from the difference. This form of arbitration requires the breach of at least one of the following three conditions:

  1. On all markets, the same security must trade at the same price.
  2. Two securities with equal cash flows must be priced the same.
  3. A security having a known future price (through a futures contract) must trade today at that price less the risk-free rate.

Arbitrage, on the other hand, may take several forms. The second kind of arbitrage that we will explore is risk arbitrage (or statistical arbitrage). Risk arbitrage, as opposed to pure arbitrage, involves—you guessed it—risk. Despite being classified as “speculation,” risk arbitrage has become one of the most popular (and user-friendly) kinds of arbitrage.

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Example of Risk Arbitrage

This is how it works: Assume Company A is now trading at $10 per share. Company B, which wishes to purchase Company A, decides to make a takeover offer of $15 per share on Company A. This indicates that all of Company A’s shares are now worth $15 per share, but they are only trading at $10 per share.

Assume the early transactions (not retail trades) bid it up to $14/share. There is still a $1/share differential, which provides a potential for risk arbitrage. So, where is the danger? If the deal falls through, the shares will be worth just the initial $10 per share. We shall look at methods to assess risk further down.

Market Makers and True Arbitrage

Market makers have several advantages over retail traders:

  • Far more trading capital
  • Generally more skill
  • Access to up-to-date news
  • Faster computers
  • More complex software
  • Access to the dealing desk

When these elements are combined, it is practically hard for a retail trader to profit on pure arbitrage chances. Market makers routinely employ complicated software that runs on cutting-edge computers to find such possibilities. Once discovered, the disparity is usually minimal and needs a large amount of cash to profit—retail traders are likely to get burnt by commission charges.

Needless to say, retail traders find it difficult to compete in the risk-free realm of arbitrage.

Retail Traders and Risk Arbitrage

Despite the drawbacks of pure arbitrage, risk arbitrage is nevertheless available to the majority of retail traders. Although this sort of arbitrage involves some risk, it is sometimes referred to as “playing the odds.” In this section, we will look at some of the most frequent types of arbitrage accessible to retail traders.

Takeover and Merger Arbitrage

The above example of risk arbitrage depicts takeover and merger arbitrage, which is perhaps the most prevalent kind of arbitrage. It usually entails discovering an undervalued firm that has been targeted for a takeover proposal by another company. This offer would bring the company’s actual, or intrinsic, worth to the surface. If the merger is successful, all those who capitalized on the chance will earn handsomely; nevertheless, if the merger fails, the price may decrease.

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Speed is the key to success in this form of arbitrage. This strategy is often used by traders that trade on Level II and have access to streaming market news. When anything is announced, they rush to participate before everybody else.

Risk Evaluation

But suppose you aren’t among the first to arrive. How can you tell whether it’s still a good deal? One approach is to apply Benjamin Graham’s risk-adjustment algorithm to estimate optimum risk/reward. The following is stated in his equations:

AnnualReturn = C G L ( 100 % C ) Y P where: C = Theexpectedchanceofsuccess(%) P = Thecurrentpriceofthesecurity L = Theexpectedlossintheeventofa failure(usuallyoriginalprice) Y = Theexpectedholdingtimeinyears (usuallythetimeuntilthemergertakesplace) G = Theexpectedgainintheeventofa success(usuallytakeoverprice) \begin{aligned} &\text{Annual Return}=\frac{CG-L(100\%-C)}{YP}\\ &\textbf{where:}\\ &C=\text{The expected chance of success (\%)}\\ &P=\text{The current price of the security}\\ &L=\text{The expected loss in the event of a}\\ &\text{failure (usually original price)}\\ &Y=\text{The expected holding time in years}\\ &\text{(usually the time until the merger takes place)}\\ &G=\text{The expected gain in the event of a}\\ &\text{success (usually takeover price)} \end{aligned} ​​

Although this is fairly empirical, it will give you an idea of what to anticipate before engaging in merger arbitrage.

Liquidation Arbitrage

Gordon Gekko used this form of arbitrage when he acquired and sold firms. The process of evaluating the worth of a company’s liquidation assets is known as liquidation arbitrage. Assume Company A has a book (liquidation) value of $10 per share and is now trading at $7 per share. If the corporation intends to liquidate, it creates an arbitrage opportunity. In Gekko’s instance, he took up enterprises that he believed might be profitable if broken up and sold—a technique used by bigger organizations.

For takeover and merger arbitrage, a variant of Benjamin Graham’s risk arbitrage formula might be utilized. Simply replace the takeover price with the liquidation price and the holding duration with the time until liquidation.

Pairs Trading

Pairs trading (also known as relative-value arbitrage) is far less popular than the previous two varieties. This kind of arbitrage is based on the existence of a substantial correlation between two linked or unrelated stocks.

This is how it works. You must first discover “pairs.” High-probability pairings are often large equities in the same industry with comparable long-term trading histories. Seek a high percentage association. Then you wait for a 5% to 7% divergence in the pairings to persist for a lengthy period of time (two to three days).Finally, depending on the price comparison, you may go long or short on the two stocks. Then just wait for the pricing to return to normal.

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GM and Ford are two examples of stocks that might be utilized in a pairs trade. These two firms have a strong link. Simply plot these two stocks and wait for a substantial divergence; chances are, these two prices will ultimately return to a greater correlation, providing an opportunity for profit.

How to Find Opportunity

Many of you are probably asking where you may locate these easy arbitrage chances. The truth is that most of the information may be obtained using freely accessible technologies. Brokers generally provide newswire services, which enable you to read breaking news as soon as it becomes available. Individual traders may also benefit from Level II trading, which can provide an advantage. Finally, screening tools may assist you in locating undervalued equities (those with an adequate price/book ratio, PEG ratio, and so on).

There are also various commercial programs that might help you find these arbitrage possibilities. Such services are particularly valuable for pairs trading, which might need greater work in identifying correlations between assets. Typically, these services will supply you with a daily or weekly spreadsheet showing prospects for profit.

The Bottom Line

Arbitrage is a wide category of trading that involves a variety of tactics; nonetheless, they all strive to capitalize on enhanced possibilities of success. Although risk-free types of pure arbitrage are often inaccessible to individual traders, there are many high-probability kinds of risk arbitrage that provide numerous possibilities for profit to retail traders.

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