The Basics of Arbitrage Trading

By: Wayne Duggan

No trading strategy is risk-free, but arbitrage trading can come pretty close when done correctly. Here’s a basic look at what arbitrage trading is and why it’s so effective.

What Is Arbitrage Trading?
Arbitrage trading occurs when an asset deviates from its fair value. Typical arbitrage trading involves the simultaneous purchase of one security and sale of an equal amount of an identical (or extremely similar) security to capitalize on short-term market inefficiencies.

Correctly constructed arbitrage trades should be market-neutral, eliminating the risk that a sharp move in the broader market or a particular market sector will disrupt the trade.

For example, BHP Group PLC (BBL) and BHP Group Ltd (BHP) are two classes of stock in the same company with equal ownership and voting rights. In theory, those stocks should always trade in tandem: if one goes down so does the other, and vice versa.

But the market is not always perfectly efficient, and it’s possible these stocks don’t always move in direct correlation. Hypothetically, a large investor could drive one stock disproportionately lower (say, BBL) by selling their entire stake, causing its price to temporarily fall more than BHP.

An arbitrage trader would recognize the short-term disparity and buy shares of BBL while selling shares of BHP and profiting off the difference when the valuations of the two share classes eventually converge again.

Merger Arbitrage
Another common form of arbitrage trading that is slightly riskier is merger arbitrage. Merger arbitrage involves buying shares of a company after a buyout is announced and capitalizing on the difference between the current share price and the buyout price. This is possible because companies being bought out typically trade at a slight discount to the buyout price, as the market prices in a slim potential that the deal falls apart.

For example, if Company A announces a buyout of Company B at a price of $10 per share, Company B’s share price may only initially trade up to $9.90 cents.

In this situation, some Company B investors may be unwilling to wait two or three months for the deal to close just to get an extra $0.10 of gains. They might want to sell and take their profit now.

An arbitrage trader, however, sees that $0.10 difference as an opportunity. If there’s very little risk involved in the merger being called off, a merger arbitrage trader may see this as a way to make a quick profit by buying at $9.90 and waiting for the deal to close. The AT&T-Time Warner merger was a great example of this.

The most common examples of arbitrage opportunities occur in:

  • Stocks that have multiple share classes, such as Viacom (VIA, VIAB) or Alphabet (GOOG, GOOGL)
  • Stocks that trade on multiple exchanges. Maybe a stock trades primarily in Canada and is listed in the U.S. via an ADR.
  • Stocks that are correlated to specific futures markets or ETFs. Amazon (AMZN), for example, makes up over 20% of the Consumer Discretionary Select Sector SPDR Fund (XLY)

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The author holds no positions in any of the stocks mentioned.

Lightspeed Financial Services Group LLC is not affiliated with these third-party market commentators/educators or service providers. Data, information, and material (“content”) are provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities or contracts. Any investment decisions made by the user through the use of such content is solely based on the users independent analysis taking into consideration your financial circumstances, investment objectives, and risk tolerance. Lightspeed Financial Services Group LLC does not endorse, offer nor recommend any of the services or commentary provided by any of the market commentators/educators or service providers and any information used to execute any trading strategies are solely based on the independent analysis of the user.

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