Trading the Odds with Arbitrage

"I don't throw darts at a board. I bet on sure things. Read Sun-tzu, The Art of War. Every battle is won before it is ever fought." Many of you might recognize these words spoken by Gordon Gekko in the movie Wall Street. In the movie, Gekko makes a fortune as a pioneer of arbitrage. Unfortunately, such risk-free trading is not available to everyone; however, there are several other forms of arbitrage that can be used to enhance the odds of executing a successful trade. Here we look at the concept of arbitrage, how market makers utilize "true arbitrage," and, finally, how retail investors can take advantage of arbitrage opportunities.

Concepts of Arbitrage
Arbitrage, in its purest form, is defined as the purchase of securities on one market for immediate resale on another market in order to profit from a price discrepancy. This results in immediate risk-free profit.

For example, if a security's price on the NYSE is trading out of sync with its corresponding futures contract on Chicago's exchange, a trader could simultaneously sell (short) the more expensive of the two and buy the other, thus profiting on the difference. This type of arbitrage requires the violation of at least one of these three conditions:

1. The same security must trade at the same price on all markets.
2. Two securities with identical cash flows must trade at the same price.
3. A security with a known price in the future (via a futures contract) must trade today at that price discounted by the risk-free rate.

Arbitrage, however, can take other forms. Risk arbitrage (or statistical arbitrage) is the second form of arbitrage that we will discuss. Unlike pure arbitrage, risk arbitrage entails--you guessed it--risk. Although considered "speculation," risk arbitrage has become one of the most popular (and retail-trader friendly) forms of arbitrage.

Here's how it works: let's say Company A is currently trading at $10/share. Company B, which wants to acquire Company A, decides to place a takeover bid on Company A for $15/share. This means that all of Company A's shares are now worth $15/share, but are trading at only $10/share. Let's say the early trades (typically not retail trades) bid it up to $14/share. Now, there is still a $1/share difference--an opportunity for risk arbitrage. So, where's the risk? Well, the acquisition could fall through, in which case the shares would be worth only the original $10/share. Further below we will take a look at how you can gauge risk.

Market Makers: True Arbitrage
Market makers have several advantages over retail traders:
• Far more trading capital
• Generally more skill
• Up-to-the-second news
• Faster computers
• More complex software
• Access to the dealing desk
• And more

Combined, these factors make it nearly impossible for a retail trader to take advantage of pure arbitrage opportunities. Market makers use complex software that is run on top-of-the-line computers to locate such opportunities constantly. Once found, the differential is typically negligible, and requires a vast amount of capital in order to profit--retail traders would likely get burned by commission costs. Needless to say, it is almost impossible for retail traders to compete in the risk-free genre of arbitrage.

Retail Traders: Risk Arbitrage
Despite the disadvantages in pure arbitrage, risk arbitrage is still accessible to most retail traders. Although this type of arbitrage requires taking on some risk, it is generally considered "playing the odds." Here we will examine some of the most common forms of arbitrage available to retail traders.

Risk Arbitrage: Takeover and Merger Arbitrage
The example of risk arbitrage we saw above demonstrates takeover and merger arbitrage, and it is probably the most common type of arbitrage. It typically involves locating an undervalued company that has been targeted by another company for a takeover bid. This bid would bring the company to its true, or intrinsic, value. If the merger goes through successfully, all those who took advantage of the opportunity will profit handsomely; however, if the merger falls through, the price may drop.

The key to success in this type of arbitrage is speed; traders who utilize this method usually trade on Level II and have access to streaming market news. The second something is announced, they try to get in on the action before anyone else.

Risk Evaluation
Let's say you aren't among the first in, however. How do you know if it is still a good deal? Well, one way is to use Benjamin Graham's risk-arbitrage formula to determine optimal risk/reward. His equations state the following:

Annual Return= CG-L(100%-C)/YP

Where:
• C is the expected chance of success (%).
• P is the current price of the security.
• L is the expected loss in the event of a failure (usually original price).
• Y is the expected holding time in years (usually the time until the merger takes place).
• G is the expected gain in the event of a success (usually takeover price).

Granted, this is highly empirical, but it will give you an idea of what to expect before you get into a merger arbitrage situation.

Risk Arbitrage: Liquidation Arbitrage
This is the type of arbitrage Gordon Gekko employed when he bought and sold off companies. Liquidation arbitrage involves estimating the value of the company's liquidation assets. For example, say Company A has a book (liquidation) value of $10/share and is currently trading at $7/share. If the company decides to liquidate, it presents an opportunity for arbitrage. In Gekko's case, he took over companies that he felt would provide a profit if he broke them apart and sold them--a practice employed in reality by larger institutions.

Valuation
A version of Benjamin Graham's risk arbitrage formula used for takeover and merger arbitrage can be employed here. Simply replace the takeover price with the liquidation price, and holding time with the amount of time before liquidation.

Risk Arbitrage: Pairs Trading
Pairs trading (also known as relative-value arbitrage) is far less common than the two forms discussed above. This form of arbitrage relies on a strong correlation between two related or unrelated securities. It is primarily used during sideways markets as a way to profit.

Here's how it works. First, you must find "pairs." Typically, high-probability pairs are big stocks in the same industry with similar long-term trading histories. Look for a high percent correlation. Then, you wait for a divergence in the pairs between 5-7% divergence that lasts for an extended period of time (2-3 days). Finally, you can go long and/or short on the two securities based on the comparison of their pricing. Then, just wait until the prices come back together.

One example of securities that would be used in a pairs trade is GM and Ford. These two companies have a 94% correlation. You can simply plot these two securities and wait for a significant divergence; then chances are these two prices will eventually return to a higher correlation, offering opportunity in which profit can be attained.

Find Opportunity
Many of you may be wondering where you can find these accessible arbitrage opportunities. The fact is much of the information can be attained with tools that are available to everyone. Brokers typically provide newswire services that allow you to view news the second it comes out. Level II trading is also an option for individual traders and can give you an edge. Finally, screening software can help you locate undervalued securities (that have appropriate price/book ratio, PEG ratio, etc.).

There are also several paid services that locate these arbitrage opportunities for you. Such services are especially useful for pairs trading, which can involve more effort to find correlations between securities. Usually, these services will provide you with a daily or weekly spreadsheet outlining opportunities that you can utilize to profit.

Conclusion
Arbitrage is a very broad form of trading that encompasses many strategies; however, they all seek to take advantage of increased chances of success. Although the risk-free forms of pure arbitrage are typically unavailable to retail traders, there are several high-probability forms of risk arbitrage that offer retail traders many opportunities to profit.

by Justin Kuepper,
Justin Kuepper has many years of experience in the market as an active trader and a personal retirement accounts manager. He spent a few years independently building and managing financial portals before obtaining his current position with Accelerized New Media, owner of SECFilings.com, ExecutiveDisclosure.com and other popular financial portals. Kuepper continues to write on a freelance basis, covering both finance and technology topics.

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Risk Arbitrage

In economics, arbitrage is the practice of taking advantage of a state of imbalance between two (or possibly more) markets: a combination of matching deals are struck that exploit the imbalance, the profit being the difference between the market prices. A person who engages in arbitrage is called an arbitrageur.

For example, if you can buy items at one price at a factory outlet and sell them for a higher price on an internet auction website such as eBay, you can exploit the imbalance between those two markets for those items. The term "arbitrage", however, is usually applied only to trading in money and investment instruments (such as stocks, bonds, and other securities), not to goods, and the difference in prices is usually referred to as "the spread", so arbitrage is often defined as "playing the spread" in the money market.

Arbitrage has the effect of causing prices in different markets to converge. As a result of arbitrage, the currency exchange rates, the price of commodities, and the price of securities in different markets all tend to converge to a fixed price. The speed at which the prices converge is one measure of the efficiency of a market. Arbitrage tends to reduce price discrimination by encouraging people to buy an item where the price is low and resell where the price is high. Sellers of goods and services often attempt to prohibit or discourage arbitrage.

Traditionally, arbitrage transactions in the securities markets involve high speed and low risk. At some moment a price difference exists, and the problem is to execute two or three balancing transactions while the difference persists (that is, before the other arbitrageurs act).

In the 1980s a practice with the oxymoronic name of "risk arbitrage" became common. In this form of speculation, one trades a security that is clearly undervalued or overvalued, when it is seen that the wrong valuation is about to be corrected by events. The standard example is the stock of a company, undervalued in the stock market, which is about to be the object of a takeover bid; the price of the takeover will more truly reflect the value of the company, giving a large profit to those who bought at the current price—if the merger goes through as predicted.

The transaction involves a delay of weeks or months and may entail considerable risk if borrowed money is used to magnify the reward through leverage. One way of reducing the risk is through the illegal use of inside information is obvious, and in fact risk arbitrage with regard to leveraged buyouts was associated with some of the famous financial scandals of the 1980s such as those involving Michael Milken and Ivan Boesky.

Examples
Here’s a theoretical example: Suppose that the exchange rates (after taking out the fees for making the exchange) in London are £5 = $10 = ¥1000 and the exchange rates in Tokyo are ¥1000 = £6 = $10. Converting $10 to £6 in Tokyo and converting that £6 into $12 in London, for a profit of $2, would be arbitrage.

One real-life example of arbitrage involves the stock market in New York and the futures market in Chicago. When the price of a stock in New York and its corresponding future in Chicago are out of sync, one can buy the less expensive one and sell the more expensive. Because the differences between the prices are likely to be small (and not to last very long), this can only be done profitably with computers examining a large number of prices and automatically exercising a trade when the prices are far enough out of balance. The activity of other arbitrageurs can make this risky. Those with the fastest computers and the smartest mathematicians take advantage of series of small differentials that would not be profitable if taken individually.

Risks
Arbitrage transactions in modern securities markets involve fairly low risks. Generally it is impossible to close two or three transactions at the same instant; therefore, there is the possibility that when one part of the deal is closed, a quick shift in prices makes it impossible to close the other at a profitable price. There is also counter-party risk, that the other party to one of the deals fails to deliver as agreed; though unlikely, this hazard is serious because of the large quantities one must trade in order to make a profit on small price differences. These risks become magnified when leverage or borrowed money is used.
Another risk occurs if the items being bought and sold are not identical and the arbitrage is conducted under the assumption that the prices of the items are correlated or predictable. In the extreme case this is risk arbitrage, described earlier. In comparison to the classical quick arbitrage transaction, such an operation can produce disastrous losses.

Long-Term Capital Management (LTCM) lost $100 billion mis-managing this concept in September 1998. LTCM had attempted to make money on the difference between different bond instruments. For example, it would buy U.S treasury bonds and sell Italian bond futures. The concept was that because Italian bond futures had a less liquid market, in the short term Italian bond futures would have a higher return than U.S. bonds, but in the long term, the prices would converge. Because the difference was small, large amount of money had to be borrowed to make the buying and selling profitable.

The downfall in this system began on August 17, 1998, when Russia defaulted on its rouble debt and domestic dollar debt. Since the markets were already nervous due to the Asian crisis, investors began selling non-U.S. treasury debt and buying U.S. treasuries, which were considered a safe investment. As a result the return on U.S. treasuries began decreasing because there were many buyers, and the return on other bonds began to increase because there were many sellers. This caused the difference between the returns of U.S. treasuries and other bonds to increase, rather than to decrease as LTCM was expecting. Eventually this caused LTCM to fold, and a bailout had to be arranged to prevent a collapse in confidence in the economic system.

An ironic footnote is that they were right long-term (the LT in LTCM), and a few months after they folded their portfolio became very profitable. However the long-term does not matter if you cannot survive the short-term, and that they failed to do.

From Wikipedia,http://en.wikipedia.org/

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Arbitrage Squeezes Profit From Market Inefficiency

The efficient market hypothesis states that financial markets are "informationally efficient" in that the prices of the traded assets reflect all known information at any given time. But if this is true, then why do prices vary from day to day despite no new fundamental information? The answer involves one aspect that is commonly forgotten among individual traders: liquidity.

Many large institutional trades throughout the day have nothing to do with information and everything to do with liquidity. Investors that feel overexposed will aggressively hedge or liquidate positions, which will end up affecting the price. These liquidity demanders are often willing to pay a price to exit their positions, which can result in a profit for liquidity providers. This ability to profit on information seems to contradict the efficient market hypothesis but forms the foundation of statistical arbitrage.

Statistical arbitrage aims to capitalize on the relationship between price and liquidity and works by profiting from the statistical mispricing of one or more assets based on the expected value of the assets generated from a statistical model. Read on to learn more about this model and how it works.

Origins of Statistical Arbitrage
Statistical arbitrage originated in the 1980s from the hedging demand created by Morgan Stanley's equity block trading desk operations. Morgan Stanley was able to avoid price penalties associated with large block purchases by purchasing shares in closely correlated stocks as a hedge against its position. For example, if the firm purchased a large block of shares, it would short a closely correlated stock to hedge against any major downturns in the market. This effectively eliminated any market risks while the firm sought to place the stock it had purchased in a block transaction.

Traders soon began to think of these pairs not as a block to be executed and its hedge, but rather two sides of a trading strategy aimed at profit making rather than simply hedging. These pair trades eventually evolved into various other strategies aimed at taking advantage of statistical differences in security prices due to liquidity, volatility, risk or other factors. We now classify these strategies as statistical arbitrage.

Types of Statistical Arbitrage
There are many types of statistical arbitrage created to take advantage of several different types of opportunities. While some types have been phased out by a more efficient marketplace, there are several other opportunities that have arisen to take their place.

Risk Arbitrage
Risk arbitrage is a form of statistical arbitrage that seeks to profit from merger situations. Merger arbitreurs (as the investors are called) purchase stock in the target and (if it's a stock transaction) simultaneously shorts the stock of the acquirer. The result is a profit realized from the difference between the buyout price and the market price.

Unlike traditional statistical arbitrage, risk arbitrage involves taking on some risks. The largest risk is that the merger will fall through and the target's stock will drop to its pre-merger levels. Another risk deals with the time value of the money invested - mergers that take a long time to go through can eat into investors' annual returns.

The key to success in risk arbitrage is determining the likelihood and timeliness of the merger and comparing that with the difference in price between the target stock and the buyout offer. Some risk arbitreurs have begun to speculate on takeover targets as well, which can lead to substantially greater profits with equally greater risk.

Volatility Arbitrage
Volatility arbitrage is a popular type of statistical arbitrage that focuses on taking advantage of the differences between the implied volatility of an option and a forecast of the future realized volatility in a delta-neutral portfolio. Essentially, volatility arbitrageurs are speculating on the volatility of the underlying rather than making a directional bet on the underlying security's price.

The key to this strategy is accurately forecasting future volatility, which can stray for a variety of reasons including:
• Patent disputes
• Clinical trial results
• Uncertain earnings
• M&A speculation
Once a volatility arbitrager has estimated the future realized volatility, he or she can begin to look for options where the implied volatility is either significantly lower or higher than the forecast realized volatility for the underlying security. If the implied volatility is lower, the trader can buy the option and hedge with the underlying security to make a delta-neutral portfolio. Similarly, if the implied volatility is higher, the trader can sell the option and hedge with the underlying security to make a delta-neutral portfolio.

The trader will then realize a profit on the trade when the underlying security's realized volatility moves closer to his or her forecast than it is to the market's forecast (or implied volatility). The profit is realized from the trade through the continual re-hedging required to keep the portfolio delta neutral.

Other Types of Arbitrage
There are many other types of arbitrage that have developed over the past decades. These include neural networks and high frequency trading. Let's take a look at these strategies and see how they represent the future of arbitrage trading:
• Neural Networks: Neural networks are becoming increasingly popular in the statistical arbitrage arena due to their ability to find complex mathematical relationships that seem invisible to the human eye. These networks are mathematical or computational models based on biological neural networks. They consist of a group of interconnected artificial neurons that process information using a connectionist approach to computation; this means that they change their structure based on the external or internal information that flows through the network during the learning phase. Essentially, neural networks are non-linear statistical data models that are used to model complex relationships between inputs and outputs to find patterns in data. Obviously, any pattern in securities price movements can be exploited for profit. (For more on this method, read Train To Gain With Neural Networks and Neural Trading: Biological Keys To Profit.)


• High Frequency Trading: High frequency trading is a new development that aims to capitalize on the ability of computers to quickly execute transactions. Spending in the trading sector has grown significantly over the years and, as a result, there are many programs able to execute more than 3,000 trades per second. Now that most statistical arbitrage opportunities are limited due to competition, the ability to quickly execute trades is the only way to scale profits. Increasingly complex neural networks and statistical models combined with computers able to crunch numbers and execute trades faster are the key to future profits for arbitreurs.
Role in the Markets
Statistical arbitrage plays a vital role in providing much of the day-to-day liquidity in the markets. It enables large block traders to place their trades without significantly affecting market prices, while also reducing volatility in issues like American depositary receipts by correlating them more closely with their parent stocks.

Statistical arbitrage has also caused some major problems, however. The most readily apparent was the Long Term Capital Management collapse, which almost left the market in ruins. In order to profit from such small price deviations, it is necessary to take on significant leverage. Moreover, because these trades are automated, there are built-in security measures. In LTCM's case, this meant that it would liquidate upon a move downward; the problem was that LTCM's liquidation orders only triggered more sell orders in a horrible loop that only ended with government intervention. Remember, most stock market crashes arise from issues with liquidity and leverage - the very arena in which statistical arbitreurs operate.

Conclusion
Statistical arbitrage is one of the most influential trading strategies ever devised, despite having decreased slightly in popularity since the 1990s. Today, most statistical arbitrage is conducted through high frequency trading using a combination of neural networks and statistical models. Not only do these strategies drive liquidity, but they are also largely responsible for the large crashes we've seen in firms like LTCM in the past. As long as liquidity and leverage issues are combined, this is likely to continue making the strategy one worth recognizing even for the common investor.

by Justin Kuepper,
Justin Kuepper has many years of experience in the market as an active trader and a personal retirement accounts manager. He spent a few years independently building and managing financial portals before obtaining his current position with Accelerized New Media, owner of SECFilings.com, ExecutiveDisclosure.com and other popular financial portals. Kuepper continues to write on a freelance basis, covering both finance and technology topics.

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Arbitrage

There is no free lunch.

Old Stock Exchange adage

Arbitrage strategies are very popular in the hedge fund world, but before turning to their description, it is necessary to clarify the specific meaning of the term “arbitrage” in this context.

From an academic point of view, an arbitrage stands for a risk-free transaction that generates an instant profit: a theoretical example of arbitrage is the concurrent purchase and sale of the same security on different markets at different prices. By buying the same security at a lower price and selling it right away at a higher price, an arbitrageur earns an immediate profit at no risk, saving the settlement and delivery risks.

But in the hedge fund business the term arbitrage has developed a different sense, in that it does not refer to risk-free positions, but rather to positions involving risks other than the market risk. Hedge fund arbitrages in practice are directional positions on spreads: if the spread widens or narrows as anticipated, the manager makes a profit; otherwise he suffers a loss. Therefore we must not be misled by the word arbitrage: a hedge fund may well suffer a loss even when it has constructed an arbitrage position – what it takes, is for the spread to widen or narrow contrary to predictions.

An arbitrage opportunity may appear when given technical, geographical, legal or administrative barriers interfere with the correct interaction between two markets trading the same security, thus preventing the security from having the same price on both markets.

In a perfect world, there would be no arbitrage opportunities, and in the real world most arbitrage opportunities tend to disappear quickly, unless there are high transaction costs that hamper frequent arbitrages. Over time, inevitably, other arbitrageurs will get organized to take advantage of arbitrage opportunities, narrowing down the price difference until it disappears. Arbitrage opportunities draw various arbitrageurs to the market, and they will erode each other’s profits by competing against one another. Once again, to make a return it is necessary to take on risks!

It is important to note that arbitrageurs are not asked to forecast the absolute movement of two securities, but rather the relative movement of one over the other, irrespective of market direction.

Any arbitrage opportunity faces so-called steamroller risks. Through a colorful analogy, an arbitrageur is seen as somebody who picks up a few coins from the ground in front of a moving steamroller: the man runs no risk provided he never forgets that the steamroller is forging ahead towards him. In order to earn a few coins the man runs the risk of being steamrolled.

Risks can also come from regulatory or tax changes, which may force the arbitrageur to close a position while losing money. Or, as illustrated below in the ADR arbitrage example, sometimes conditions regulating the short sale of a security may change suddenly, and the security may be called in by the owner; or sometimes the borrowed security may pay out a dividend, which is going to represent an unexpected cost for the arbitrageur.

The greater the number of arbitrageurs operating on a given market, the higher the competition, which means that the returns realized by the arbitrageurs will be lower. The current trend in the hedge fund business is that the massive money flow towards arbitrage strategies makes it more and more difficult for managers to generate interesting returns.

Most of the low-hanging fruits have already been picked!

This article is a part of “Investment Strategies of Hedge Funds” ebooks by Filippo Stefanini for closed private educations only. You should buy his books for the best completely informations.

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