What is Arbitrage?

The first thing you should know about how to arbitrage is that the execution of your pair trade should always occur simultaneously. Arbitrages strategies can be used with almost any kind of financial instrument, fund or commodity, where there are market inefficiencies.

The pair trade nature of an arbitrage technique consist on taking a long position (buying) of a security while at the same time shorting (selling) other position; in the same asset class. Which are currently being mispriced, but that in the future they will have the highest prospect of converging. That is to say that the overpriced security will be devalue and that the underpriced security will appreciate.

Arbitrage by definition is believed to be the only risk-free strategy on Wall Street; though I am not so sure about that. Arbitrage is, at least, one of the lowest risk investment strategies there is in any financial market. Hedge funds love to arbitrage because it is a market neutral trade making it a low risk tactic and one of the most profitable trading strategies on history.

Arbitrage Basics

The Risk of Arbitrage

Arbitrageurs of the arbitrageportfolio.com community should not believe that arbitrage is a risk free trade; there are in fact many risks involved. For me the most important risk to be aware of is the asymmetric risk.

Asymmetric risk: is the chance of small profits at the risk of greater potential losses. Arbitrage is a profitable technique, but it is usually gives you only pennies on a dollar at the possible cost of quarters on the dollar; if the worst were to happen. Bankers have huge amounts of money and access to superior technology and information which help them reduce their risk exposure and multiply their gains; turning pennies into millions.

For each asset class (bonds, commodities, currencies, derivatives, futures, stocks, etc.) there is a respective arbitrage strategy. Say for example, (ON DEC 2010), crude oil was providing an arbitrage opportunity. In order to exploit it, an arbitrageur will have to buy crude at WTI prices while selling it at the same time at Brent oil prices pocketing the difference (the spread) on prices, after transactions costs are paid.

Mergers and Acquisitions Arbitrage

However, the most popular way to arbitrage is with equities also known as merger or risk arbitrage. If you follow the markets as well as I do you will have noticed by now that when a merger or an acquisition is announced, the target company stock usually don’t trade in the markets at the full announced price. This happens because there are many risk and uncertainties involved that may cause the deal to fall apart. These issues and risks can be discovered easily by carefully reading the Definitive Merger Agreement (DMA) before taking a position on the trade. The risk arbitrage trade is very dynamic, that is why you must follow every little detail and every piece of news about the deal to avoid possible loses; case on point the NYSE Euronext and Deutsche deal. Also diversify across different deals, and do not bet all your money in only one position.

How to Arbitrage Tools

Merger arbitrage requires some speculative exposure and here in the arbitrageportfolio.com comunity, we don’t focus in speculation; rather we focus on income. The reason why I suggested interest spread arbitrage instead, under the arbitrageur systemic approach.

Learn how to arbitrage like a banker and begin to exploit the advantages of interest spread arbitrage. Just then you may start achieving your financial independence; by utilizing the characteristic of borrowing (amortization) versus the arbitrage characteristic of saving (capitalization) in your favor. I invite you to take action today and start arbitraging, invest in our product, (The Arbitrageur Investing System)  and discover the profitability of interest spread arbitrage.

Case Study Time

Develop a template on an excel spreadsheet that can be adjusted for cash, stocks, mergers and acquisitions. “Arbitrage Trading”