5 Types of Arbitrage Plays Available to You
- The one thing every arbitrage opportunity hinges on…
- Two environments that arbitrage can happen in…
- Using trading software to your advantage…
Dear Penny Stock Millionaire,
A pure arbitrage play doesn’t have any risk. Unfortunately, pure arbitrage opportunities don’t present themselves very often.
In a perfect execution, you buy a security with one hand and sell it with the other. We already talked about leg risk, but if you have a setup where you can sell what you don’t have, there’s no inherent risk.
You know the market price in both exchanges, so you’re guaranteed to make money.
Every arbitrage opportunity hinges on price inefficiency.
In other words, one exchange is slow on the uptake when it comes to a security’s market value.
Hedge funds and traders that use arbitrage frequently seek small, low-risk returns. In other words, they’re not raking in millions every day for their customers or for themselves because modern technology prevents serious price inefficiencies.
Back to my story about buying a rare book in a bookstore and selling it for a huge profit on eBay. It could be considered arbitrage if you listed the book at the same time you bought it, though there would be a delay in selling it and collecting the fee.
Arbitrage can happen in those two environments because they’re completely separate. The bookstore doesn’t automatically know what eBay buyers will pay for the book, and eBay doesn’t care what the store sells the book for.
On securities exchanges, however, price variations are far narrower when they happen at all because everyone knows what everyone else is doing. One exchange might be a few minutes or hours behind another, but it’s rare.
Arbitrage Possibilities and Opportunities
The biggest arbitrage opportunity lies in trading software. If you have powerful enough software, you can use it to detect minute variations in securities’ prices and capitalize on them.
However, it’s going to cost you.
Automatic, trade-alert, and remote-alert software programs can set you back thousands of dollars. Furthermore, they’re not as powerful as the commercial-grade software used by big hedge funds and investment banks.
These software programs detect small fluctuations in price that last just a few seconds. They execute the trades automatically based on preset criteria so the trader doesn’t have to run manual calculations.
Without some sort of automatic software, it’s nearly impossible to capitalize on stock market arbitrage. The opportunities don’t last long enough.
Learn to Hone Your Skills with Professional Assistance
Traders sometimes “box” positions, which means that they take a long and a short at the same time.
For instance, if its merger arbitrage, you might bet that the merger will benefit one company more and hurt the other, and that the prices will eventually reflect it in the stocks’ prices.
Going long and short in a merger arbitrage play might seem like a smart idea, especially if there’s been lots of fundamental information about the merger. But that means everyone else has the same information.
My advice: steer clear. Instead, consider sticking with my simple, more retail trader-friendly patterns that all the fancy, high-end computers don’t care about.
The multi-billion-dollar investment companies have endless amounts of computer data and pricey research that normal people like us don’t have access to. I prefer to play a game I can win.
The 5 Types of Arbitrage
Though I’m opposed to using arbitrage, you can still familiarize yourself with the concept so you’re aware it exists.
I’m all for education, so let’s look at a few distinct types of arbitrage and how they play out in the market.
1. Financial Arbitrage
In most cases, financial arbitrage refers to FOREX trading — foreign exchange trading, for the uninitiated. FOREX arbitrage occurs when you go long and short simultaneously on the exchange rates between two currencies.
Essentially, you see that the exchange rate is different between two separate exchanges. By buying on one and selling on the other, you profit.
2. Statistical Arbitrage
I won’t try to explain the mathematics behind statistical arbitrage (aka StatArb) because it’s too complex and far outside the scope of this article. Just know that it’s similar to pairs trading, but on a much bigger scale.
Those who participate in StatArb find hundreds or even thousands of stocks that are expected to move in statistically similar ways, but in opposite directions. Using complex trading software, they capitalize on those price movements by buying long and short positions, depending on the specific security.
3. Dividend Arbitrage
Dividend arbitrage involves buying a certain amount of stock, then buying put options on the same amount of stock. This occurs prior to the ex-dividend date. After the trader collects the dividends, he or she exercises the put option.
It’s a hedging strategy that requires dense mathematical formulas and expertise in options trading.
These are just the first three types of arbitrage available to you.
I have two more to cover tomorrow as well as some examples to share with you. Like I said, arbitrage is not my favorite — but I believe you should be well versed in all areas in order to become a better trader.