Arbitrage Trading

Arbitrage is the simultaneous purchase of a good or asset in one market where the price is low, and sale of the same good or asset in another market where the price is higher. “

“An arbitrageur is the individual who undertakes the simultaneous transaction between the two markets to take advantage of price discrepancies with the view of profiting from this so-called risk-free series of transactions”

Who said markets are perfect?

Like all systems, markets need checks and balances. Arbitrage exists as a result of market inefficiencies; it provides a mechanism to ensure prices do not deviate substantially from fair value for long periods of time. All textbook economists work from the first year university theory that all markets will eventually find equilibrium. A market in true equilibrium provides no arbitrage opportunities. In practice however, arbitrage is everywhere from house prices to financial instruments to general information.

In finance “theory”, an arbitrage is a transaction that makes a profit without risk. Suppose a futures contract trades on two different exchanges. If, at one point in time, the contract is bid at $45.02 on one exchange and offered at $45.00 on the other, a trader could purchase the contract at one price and sell it at the other to make a risk-free profit of a $0.02. Multiply that by multiple purchases and you can see the interest in this style of trading.

Boiled down, such arbitrage opportunities reflect minor pricing discrepancies between markets or related instruments. The arbitrageur facilitates the finding of market equilibrium. Per-transaction profits tend to be small, and they can be consumed entirely by transaction costs. As such, arbitrage is conducted by a relatively small number of highly specialized investors who take large positions using other people's money.

But there's a catch. With all forms of arbitrage, the potential to profit only exists as long as there's an exploitable difference between simultaneous markets. As markets become more efficient, the window for profit begins to slowly close because more people are able to perceive differences in information markets.

Today, the label arbitrage is often applied to the speculative trading strategies often associated with hedge funds. These include pairs trading, and merger arbitrage. Many such strategies are based on a statistical analysis of the past relative performance of two or more instruments. Based on this, an arbitrageur looks for transactions that appear more likely than not to be profitable.

Collectively, such strategies are called statistical arbitrage. Statistical arbitrage strategies often make consistent profits but with occasionally spectacular losses. Because of their skewed payoffs, statistical arbitrage strategies have been likened to picking up nickels in front of a steamroller. In 1998, hedge fund Long Term Capital Management failed due to massive losses from statistical arbitrage. It all sounds a great, but being too methodical and too mathematical can lead to a downfall, as there is no objective analysis. For their part, they forgot to take in to account sovereign risk: the concept of a country honouring its debt.

Take away all the labels and strange sounding words, arbitrage theory is theoretically a risk-free play: the ideal model of a free lunch. In practice, it an efficient method of ensuring the market finds equilibrium, risks and all.