A Hedge Fund Manager's Guide To Arbitrage Trading

Asia's Tech News Daily

Trading has become more popular with a wider cross-section of people in recent years, as brokerage firms have become more accessible and cost-efficient to everyday investors. Most brokerage firms have transitioned to a low or zero commission business model on non-margin stock trades. In addition, brokers such as Robinhood allow users to trade in fractions of shares, eliminating the barrier to entry of investing in costly per-share stocks such as Amazon, Google, and Berkshire Hathaway.

A Hedge Fund Manager's Guide To Arbitrage Trading

Handout

Still investors with limited experience should tread lightly when executing their own trades. Very few investors are able to outperform the market at large; in fact, in recent years, a majority of hedge funds have struggled to outperform the S&P500.

Arbitrage trading is a low-risk, low-reward trading strategy, in which an investor capitalizes on short-term variations in price between two equivalent or identical assets. If an investor purchased an asset for $1.00 in one market, while simultaneously selling the same asset for $1.05 in another market, this would be an example of a textbook arbitrage trade. Although most market arbitrage opportunities are quickly eliminated by lightning-fast trading bots, some arbitrage plays are overlooked by large trading firms and can be capitalized on by everyday investors.

Kane Kalas, a full-time investment manager and founder of the hedge fund Crystal Oak Capital, utilizes arbitrage strategies in his funds, and thus has unique expertise in explaining the benefits of this form of trading.

Arbitrage Trading Strategies

Below are four arbitrage strategies commonly utilized by hedge fund managers and savy investors:

Risk Arbitrage (aka Merger Arbitrage): Mergers often have the effect of raising the per-share price of the acquired company and lowering the per-share price of the acquiring company. This is because acquiring companies usually pay a premium in a merger. After a merger is announced, arbitrage traders buy the stock of the acquired company and sell short the shares of the acquiring company, until the shares of the two companies trade at or near efficient market prices.

Retail Arbitrage: This practice involves purchasing goods from a cheaper market then reselling the same goods in a more expensive market for a profit. “We Buy Gold” shops engage in this type of arbitrage by purchasing gold from the public below market price and then selling the gold at or above market price.

Convertible Arbitrage: Due to the illiquidity of the convertible securities market, convertible securities are often underpriced. Arbitrage traders can therefore profit by purchasing convertible securities of a particular company and simultaneously short selling the company’s common stock.

Statistical Arbitrage: Some distinct financial instruments trade with a high degree of correlation. Statistical arbitrage occurs when a market participant first observes that Asset A and Asset B trade in a highly correlated manner. Then the market actor observes that Asset A has changed in price while Asset B has not. The market actor then buys or sells asset B to match the change in price to asset A, reasoning that the two assets should move in price alongside one another. For example, gold mining stocks rise and fall in a highly correlated way with the price of gold. If an arbitrage trader observes that the price of gold has risen substantially but the price of a particular gold mining stock has remained constant, he or she might execute a statistical arbitrage trade by purchasing shares of the gold mining stock. Since statistical arbitrage does not involve simultaneously buying and selling the same asset, it is more risky than other forms of arbitrage and is not considered pure arbitrage in the strictest sense of the word.

The Benefits of Arbitrage Trading

As an expert with years of experience executing various arbitrage strategies, Kane Kalas expounded on the main benefits of arbitrage trading. These include:

Low Risk Profile: Arbitrage trading results in profits with minimal or no market exposure since selling and buying are carried out simultaneously, capitalizing strictly on price variations. Pure arbitrage trades, therefore, are delta neutral.

Emotional Tranquility: Trading based on emotion is the number one cause of trading losses among amateur traders. Arbitrage trading takes the emotion out of trading almost entirely. Due to its systematic nature, arbitrage investors execute only calculated trades with visible alpha, dramatically limiting the importance of intuition and reducing the likelihood of emotional trades.

Is Arbitrage Trading for Me?

In the age of high frequency trading bots, undiscovered arbitrage opportunities are becoming harder to come by. Fortunately, though, arbitrage as a strategy is executable in just about any market including commodities, stocks, forex, cryptocurrency, and even markets outside of traditional finance such as trading cards, collectibles, art, and sports betting!

Whether you are a full-time professional trader or just trying to pick up some extra cash on the side, Kalas believes that keeping an eye out for arbitrage opportunities is well worth it.

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