What is arbitrage trading and how to arbitrage trade?

What is arbitrage trading?

Arbitrage trading focuses on exploiting temporary price differences between identical assets found in different markets. Factors such as supply and demand imbalances, trading volume, and geographical limitations can cause price discrepancies. Arbitrageurs seek to profit from the result of market inefficiencies by purchasing an asset at a cheaper price in one market and selling it at a higher price in another.

This financial investment activity, which involves finding and executing trades quickly before market conditions return to normal, requires significant capital, in-depth market knowledge, and advanced trading technology. Arbitrage, often perceived as a low-risk strategy due to effective hedging of positions, nevertheless involves managing various risks associated with specific trade types.

While price differences are typically small and short-lived, the cumulative impact can be substantial when executed on a large scale. Consequently, arbitrage is frequently used by hedge funds and other sophisticated investors.

Best arbitrage trading strategies

While the term "best" can be subjective, the following arbitrage types have historically been popular and effective:

Pure arbitrage

Pure (cross-market) arbitrage is the practice of taking advantage of price differences across different exchanges for the same asset. For example, if a share of Company XYZ trades at $50 on the New York Stock Exchange (NYSE) and $52 on the NASDAQ, an arbitrageur would buy the stock at $50 on the NYSE and sell it at $52 on the NASDAQ. This would provide a profit of $2 per share.

However, such opportunities are rare due to the high-speed trading algorithms used by institutional investors and arbitrage firms. These algorithms quickly detect and exploit price differences, making it difficult for regular investors to profit from pure arbitrage.

Merger arbitrage

Merger arbitrage involves purchasing shares of a company that is being acquired and then selling them after the merger is completed. This strategy exploits the difference between the current stock price and the proposed acquisition price, so it’s a riskier and longer-term arbitrage activity. Unlike pure arbitrage, which is profitable if completed quickly, merger arbitrage entails counting on the deal's success. Regulations or unexpected hurdles can jeopardise the transaction, resulting in losses.

Convertible arbitrage

Convertible arbitrage is a trading strategy focused on convertible bonds—debt securities that can be exchanged for a company's shares under specific conditions. This involves taking simultaneous long and short positions in the convertible bond and the underlying stock.

An investor will buy the convertible bond (enter a long position) and sell (short) the stock if they believe it is undervalued relative to the company's stock price. In contrast, they will short the bond and buy the stock if it is overvalued.

The arbitrageur’s goal is to profit from the price difference between the convertible bond and the underlying stock. As the relationship between the bond and stock price changes, the arbitrageur adjusts their positions to maintain a balanced portfolio and capitalise on the price differences.

Triangular Arbitrage

Triangular arbitrage is a more complex trading strategy that exploits price discrepancies among three currencies. It works by first converting one currency into another, then the second into a third, and finally converting the third back into the original currency.

Because of the limited profit margins involved, this technique requires significant capital and excellent execution capability. Markets tend to swiftly fix price imbalances, limiting these chances.

Triangular arbitrage can also apply to cryptocurrency. For example, a trader might convert Bitcoin to Ethereum, then Ethereum to Litecoin, and finally Litecoin back to Bitcoin, taking advantage of any exchange rate differences.

Arbitrage funds

Arbitrage funds are mutual funds that capitalise on price disparities between the cash and futures markets. By simultaneously buying and selling securities, these funds aim to generate consistent, moderate returns with relatively low risk, making them attractive to risk-averse investors.

What is an arbitrage opportunity?

An arbitrage opportunity comes up when there is a price difference between marketplaces for the same asset. This imbalance allows traders to benefit by simultaneously buying the asset at a lower price and selling it at a higher price.

To illustrate an arbitrage opportunity and the challenges involved, consider a well-known example of successful Bitcoin arbitrage, starring none other than the controversial former CEO of FTX, Sam Bankman-Fried.

One of Bankman-Fried's early ventures capitalised on the "kimchi premium," the big difference in the price of Bitcoin between US and South Korean exchanges. Due to high demand and regulatory constraints in South Korea, Bitcoin traded there for $15,000, compared to $10,000 in the US.

Recognising this discrepancy, the former Jane Street trader profited by buying Bitcoin in the US and selling it in Korea.

Bankman-Fried also discovered other arbitrage opportunities, such as the Bitcoin premium in Japan. Although lower than the kimchi premium, this was more scalable because of fewer regulatory hurdles. Opportunities such as these thrived in the decentralised crypto ecosystem, which allowed for significant price discrepancies across markets.

Sam faced several challenges in exploiting arbitrage opportunities:

• The Korean won's regulated nature made it difficult to scale arbitrage operations involving the Kimchi premium.
• Navigating logistical hurdles, such as finding platforms to buy Bitcoin on a large scale and obtaining approval for Japanese exchanges, was also a challenge.
• The complex operation of moving millions of dollars out of Japan and into the US required a sophisticated global corporate framework.
• Understanding and managing counterparty risk was crucial in the decentralised crypto ecosystem.
• Scaling operations to handle large volumes also posed additional difficulties.

How does arbitrage trading work?

Hedge funds and institutional investors employ sophisticated algorithms to scan multiple markets for price discrepancies. These disparities, often arising from information delays or geographic differences, present potential arbitrage opportunities. Traders then evaluate the profit potential, factoring in trading costs, before executing simultaneous buy and sell orders. High-frequency trading bots are often deployed to capitalise on these fleeting opportunities, requiring rapid execution, diversified portfolios, and substantial capital to generate significant returns.

Traders engage in arbitrage trading because of its potential for low-risk profits. However, market volatility, transaction costs, competition, information delays, regulatory changes, counterparty risk, and operational difficulties can all impact arbitrage. These factors can quickly erase arbitrage opportunities, lead to losses, and make it challenging to consistently profit.

How to arbitrage trade

Let's look at the basic steps involved in cross-market and merger arbitrage.

How to arbitrage trade for cross-market price differences

1. Start by looking for markets, such as stock or cryptocurrency exchanges, where the same assets are exchanged.
2. Find assets, like stocks, cryptocurrency, or commodities, that are valued differently across separate platforms, using specialised tools to track prices in real-time.
3. After identifying a price difference, subtract trading expenses to ensure that the potential profit outweighs the expenses.
4. Execute simultaneous purchase and sell orders on separate exchanges. Speed is crucial to capitalise on these brief opportunities.
5. To lower risk, use stop-loss orders, diversify your investments, and monitor the market.
6. Leverage high-frequency trading (HFT) for maximum efficiency.

How to arbitrage trade in merger arbitrage

To capitalise on the disparity in value between a target firm's stock and the proposed acquisition price:

1. Identify companies involved in publicly announced mergers where the target company's stock is trading below the offer price.
2. Conduct thorough due diligence on both companies, considering their financial standing and the merger's strategic justification.
3. Assess the potential profit by comparing the offer price to the current stock price, factoring in costs and risks.
4. If the analysis is positive, invest in the target company's stock.
5. Keep a close eye on the merger's development, including regulatory approvals and potential challenges.
6. Be prepared for potential contract collapses, regulatory hurdles, and market changes that could impact the investment.
7. Once the sale is complete, sell the stock for a profit at the offer price.

How to become an arbitrage trader

To become an arbitrage trader, you must have a specialised skill set that is based on financial markets. Specific skill sets can include quantitative analysis, statistical modelling, programming (Python, R, and C++), risk management, and an understanding of financial instruments.

Aspiring arbitrageurs should have a thorough understanding of global financial markets, economic indicators, and regulatory environments.

Technical expertise in high-speed trading platforms, data analysis tools, and risk management software is also essential. This includes mastering market analysis techniques, platform-built tools, and third-party tools. A thorough understanding of the systems you will use for trading is crucial, as speed is critical in capitalising on transient price differences.

Furthermore, arbitrage requires not only experience but also sophisticated technology. Powerful computers, high-speed internet connections, and specialised software are essential for real-time data processing and rapid trade execution. Custom-built systems often leverage cloud computing and data analytics to handle large datasets and detect arbitrage opportunities.

Finally, arbitrage trading also typically requires substantial financial backing. Given the often tiny profit margins, large trades are necessary to accomplish meaningful returns.

How to make money with arbitrage

Exploiting differences in asset pricing across markets generates arbitrage profits. The wider the difference and the faster the execution, the greater the possible profit.

The risks of arbitrage trading

Cross-market and crypto arbitrage carry significant risk, as market characteristics like liquidity, volatility, and transaction costs can impact profitability. Technological issues, such as system failures and latency, can also hinder the execution of trades. The regulatory landscape, especially in crypto, increases the complexity and risk of arbitrage activities. Additionally, the competitive nature of arbitrage demands ultra-fast execution and sophisticated technology. To be successful, traders must be diligent in risk management and have a thorough understanding of market dynamics.

Merger arbitrage also carries significant risks. If the merger fails, it can lead to significant losses. Antitrust issues and other regulatory matters can lead to the delay or cancellation of agreements. Economic downturns and industry-specific challenges can also block a deal from closing. Accurately valuing the target company is crucial, as valuation errors can result in big losses. Diversifying investments, conducting thorough due diligence, and closely monitoring market conditions can help to limit these risks.

Historically, certain arbitrageurs have engaged in insider trading, using non-public information to profit from mergers. Such actions are not only risky, but they are also illegal and carry severe penalties. Legitimate arbitrage relies on identifying and exploiting price discrepancies legally and ethically.

Advantages of arbitrage trading

Arbitrage trading offers several potential benefits. Primarily, it is considered a relatively low-risk strategy in comparison to other investment methods. Unlike traditional trading, which relies on market predictions, arbitrage profits from price discrepancies, reducing exposure to market fluctuations. When executed correctly, it can generate consistent returns and serve as a valuable component of a diversified investment portfolio.

Disadvantages of arbitrage trading

Arbitrage trading also has its challenges. Arbitrageurs must be able to execute trades swiftly and efficiently to capitalise on temporary price differences. This often requires advanced technology and high-speed trading capabilities.

Profit margins in arbitrage are typically slim, necessitating high transaction volumes to achieve profitability. Transaction costs can significantly erode returns, especially on smaller trades.

The competition is also fierce, with many traders competing for limited arbitrage possibilities. Furthermore, market volatility can disrupt arbitrage efforts, as sudden price changes can eliminate potential profits.

Given its competitive nature, small profit margins, and technological requirements, arbitrage is a strategy primarily employed by institutional investors and hedge funds with the resources to handle large trade volumes. Because of these factors, individual investors typically struggle to profitably implement arbitrage strategies.

Conclusion

Arbitrage trading demands specialised skills, substantial financial resources, and advanced technology. While it offers the potential for low-risk profits, the competitive landscape and complex nature of execution make it unsuitable for most individual investors. However, for those equipped with the necessary tools and knowledge, arbitrage can be a lucrative strategy and a valuable component of a diverse investment portfolio.

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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.