Arbitrage

Arbitrage is a technique used to take advantage of differences in price in substantially identical assets across different markets or in different types of instruments.

The process involves the simultaneous buying and selling of an asset in order to profit from a discrepancy in the price in two different markets or exchanges. The existence of arbitrage opportunities helps keep financial markets efficient and liquid, and ensures that large price deviations do not exist for extended periods.

Arbitrage Example

Let’s say an exchange-traded product (ETF) is trading for $50 per share and its intrinsic price based on its individual components should be $50.10.

An arbitrageur will come into the picture and buy the ETF while simultaneously selling the individual stock components in the appropriate proportions – that is, sized to the weighting of the individual components and monetary amount of the long position in the ETF – until the price discrepancy is eliminated.

Arbitrage in Day Trading

Below are examples of arbitrage that day traders can realistically employ:

Merger Arbitrage

Because of modern-day technology, it is difficult for traders to take advantage of traditional statistical price arbitrage opportunities in the market. Proprietary trading firms and hedge funds often exploit these opportunities within a matter of seconds (sometimes even a fraction of a second) with high-powered computing capacity, leaving little opportunity for those with less sophisticated technology.

There are, however, different type of arbitrage in the market outside of basic statistical arbitrage. For example, there is a type of strategy known as “merger arbitrage” (sometimes called “takeover arbitrage”) in the market where traders attempt to arbitrage out risk in the markets.

Example

When company A seeks to buy company B, the former will usually pay the latter a premium – i.e., an amount above fair market value – in order to take control of the firm. If company B is trading at $100 per share before the takeover announcement and company A publicly announces that it will be buying its target for $125 per share, the market will never re-price company B at this new $125 takeover price.

This is due to the fact that it’s possible company A will retract its offer, company B may turn it down (or demand a higher price or engage in other negotiations), regulators may either block the deal or ask one or both companies to meet specific conditions that one or both sides may not be willing to meet, or some other third-party intervention could alter the prospective transaction.

Therefore, company B may price somewhat lower than the $125 takeover price, such as $120 to reflect an 80% chance of the deal closing – that is, high but not certain.

At the same time, because company A is paying beyond the market’s believed fair price for company B (and due to other factors, such as integration risk), company A’s price may fall from its current point in the market.

If company A was trading at $100 per share, it may fall to something lower, such as $96. Given the transaction has some chance of not occurring, the market would price company A’s stock at closer to $95 if there was a 100% probability of the deal going through to completion.

If a merger arbitrage trader believed that the transaction would follow through to completion – or at least has higher odds relative to those priced in – he or she would go long the target (company B trading at $120 per share) and short-sell the acquirer (company A trading at $95 per share).

Relative Value Arbitrage

If two stocks historically have high levels of correlation, it would be expected that, unless their business models fundamentally change, this correlation would continue to hold up.

Example

Goldman Sachs (GS) and Morgan Stanley (MS) have a correlation of 80% since both began trading simultaneously in May 1999. This correlation has run as high as 96% and as low as 50%

arbitrage

If one observed that the current correlation was in the 50%-60% range and was due to Goldman Sachs rising more than its competitor, one could take advantage of this potential opportunity by short-selling Goldman and buying Morgan Stanley. Eventually, the trading pattern between the two could be expected to revert to the mean, after which one would close the position once the correlation normalized.

Liquidation Arbitrage

Liquidation arbitrage is a type of trading by which one invests in stocks trading below their book value. The basic metric to evaluate such cases is the price-to-book ratio (P/B). If P/B < 1 – put another way, the sum of its parts is greater than the whole – then a company is trading below its book value and would be theoretically more valuable than its current stock price if the company were liquidated.

Banks commonly trade at under their book value in environments of low interest rates, flat or inverted yield curves, and high amounts of regulation.

This strategy, like others, is not foolproof. A catalyst generally needs to emerge to push the market in the right direction rather than rudimentary measures of a particular security being cheap.

This is a common strategy under the umbrella of “value investing”.

Net-net Arbitrage

This is a form of liquidation arbitrage but involves a more conservative version of the strategy. Net-net is defined as net working capital (current assets minus current liabilities) minus the long-term portion of debt – i.e., debt with maturity of greater than one year in the future (debt coming due within one year is part of current liabilities).

Some define it as net working capital minus all liabilities. When this value is greater than the market value of equity, this would suggest that there is a high chance that, should the company be liquidated, shareholders would receive more than the stock’s current value. Or the company may be poorly managed and better unlock or realize its value under new stewardship.

Why do these opportunities occasionally exist?

For one, net-net stocks tend to be smaller capitalized stocks and more easily escape Wall Street’s attention.

As companies, they may be “in limbo” and neither value-creating nor susceptible to insolvency risk in the short- or intermediate-term, leading the share price to lag what might be implicated by its balance sheet for extended periods of time.

Moreover, investors might believe that the value of its assets may be overrepresented on its balance sheet (e.g., forthcoming markdown of inventory value) and thus may truly not be an opportunity with a high margin of safety.