As we all already know, trading can be complicated. That’s why traders carefully build strategies based on various analyses of the market, with the goal of converting their initial investments into profits.
The strategies used in trading vary depending on the current trend (which is also a type of strategy), the trader’s knowledge and understanding of the market, the trader’s experience, the security type, and the amount the trader is willing to invest.
In the world of trading, we see commonly-used and unique strategies. One of these strategies is trading arbitrage.
In this article, we’ll discuss what arbitrage is and how traders use it. We’ll also check out some examples and discuss whether this trading method can be used in options.
What Is Trading Arbitrage?
Arbitrage isn’t some sort of complicated trading strategy. On the contrary, it includes buying and selling the same asset at the same time in different markets. The goal is to take advantage of the difference between the prices in the different markets.
Think of it this way - a particular asset is available for purchase in two different markets. There’s a small difference in the asset’s price between the markets. The trader buys the asset from the first market at a lower price and sells it on the other market at a higher price. Simple as that!
How do arbitrage opportunities occur?
Even if you understand the concept of profiting out of differences in the markets, you may wonder how those differences occur.
The first thing you must keep in mind is that arbitrage opportunities are rare these days. That’s because more and more traders use algo strategies. They rely on specific software to track down market movements.
Algorithms see what traders don’t, and traders who use algos execute trades faster than others, which results in higher market liquidity and resolving the differences between markets.
However, algos can’t resolve all market inefficiencies. Therefore, traders can take advantage of the differences and apply arbitrage strategies and profit.
Let’s talk about these inefficiencies, so you can understand the opportunities arbitrageurs use.
Market inefficiencies
An inefficient market is a market in which a particular asset isn’t priced according to its true value. This condition may result in huge losses and, in some cases, a market failure.
Markets always have at least a tiny level of inefficiencies. That’s because we don’t have ideal conditions. In ideal conditions, the market will show the true value of a particular asset, along with all available information on the asset.
When we don’t have access to all information about a particular asset, that results in a price that’s not equal to the asset’s true value. Other reasons for market inefficiencies are the transaction costs, market psychology, and even the traders’ emotions and instinct.
Assets that can be used for arbitrage
Various instruments can be used for arbitrage. Traders, investors, institutions, and hedge funds can build their arbitrage strategy on various types of commodities, currencies, and stocks. Lately, crypto arbitrage trading is also very popular.
Types of Arbitrage
Now that we’ve explained trading arbitrage in simple words, it’s time to dive a little deeper. Even though the concept of trading with this strategy remains the same, there are multiple types of arbitrage that you should know of.
Retail arbitrage
Retail may be the most simple type of arbitrage, as it’s very easy to understand. Retail arbitrage is a trading activity that includes a particular security. Assuming the security is very popular or rare, it’s sold at one price on one market.
The trader buys the security and immediately resells it on another market at a higher price. The goal is to gain quick profit.
Merger arbitrage
Merger, also known as risk arbitrage, is a trading action that includes acquiring companies and leveraging mergers.
The trader buys and sells stock of two merging firms at the same time. It’s considered the riskiest arbitrage because the trader doesn’t know whether the deal will be completed between two firms.
In a way, merger arbitrage is event-driven investing because the asset’s price varies before and after an acquisition or a merger. The trader aims to take advantage of those price differences.
This trading activity can include cash or stock mergers. For instance, if a company wants to acquire another one, it may buy shares of the target company for cash. On the other hand, a stock-for-stock trade may also occur. For example, the acquiring firm can exchange its stock for the target firm’s stock.
In stock merger arbitrage, the trader buys shares of the target firm and goes short on the acquiring firm’s stock. If the deal goes well, the trader uses the target firm’s stock (now converted into acquiring company’s stock) to cover the short position.
An interesting thing to keep in mind is that the trader can apply the same strategies but with options, meaning the trader can buy shares of the target company and put options on the acquiring firm at the same time.
Forex arbitrage
This is another type of arbitrage in which the trader takes advantage of the price differences in the forex markets. Simply put, the trader buys and sells currencies that have different values in different markets at the moment. This is fast trading - the arbitrage can be opened and closed in seconds and even milliseconds sometimes.
Forex trading opens the path for establishing various arbitrage or non-arbitrage strategies. Triangular arbitrage is one of those methods that are unique to forex markets.
Triangular arbitrage represents a strategy to profit from the differences between three currencies when their exchange rates don’t match up. These disparities rarely occur as the forex market becomes more and more sophisticated. However, they can occur sometimes, and when they do, advanced and experienced traders who use algos are able to spot them and execute trades.
If the trader employs triangular arbitrage, they practically exchange a particular amount of one currency at one rate, then convert the currency into another one, and finally, they convert it again into the original currency. Since the differences are very small, the trader has to invest a lot.
Statistical arbitrage
Here is a strategy within a strategy. Statistical arbitrage is a trading method that includes multiple strategies in one. The trader employs various analyses and invests in multiple portfolios.
Statistical arbitrages belong in the group of market-neutral strategies. It includes opening and holding both a long and short position at the same time. Just like other types of trading arbitrage, the goal is to benefit from the price differences of a particular asset.
Arbitrage in Options
So far, we have covered several arbitrage strategies that are commonly used by traders, hedge funds, and institutions. Of course, there are many other trading methods inspired by arbitrage, mainly because each trader aims to create a style that’s the most suitable for them.
In the next sections, we’ll inform you about two more arbitrage strategies. They’re different from the ones we discussed above because they are closely related to the link between an asset and its derivative, including options trading.
Convertible bond arbitrage
Convertible arbitrage is used when the trader wants to profit on the price differences between a convertible bond and its underlying. A convertible bond is a hybrid security that yields interest payments and can be converted into shares.
So, how does this work?
Shortly put, the arbitrage includes opening and holding a long and short position simultaneously on the convertible bond and on its underlying asset. When there’s a market movement in the price, the trader can profit if they have a suitable hedge between both positions.
In these conditions, the bondholder has a long position on a call option. On the contrary, the trader that issues the convertible bond holds a short position on a call option.
Conversion arbitrage - arbitrage in options trading
Here is a trading arbitrage strategy widely known among options traders. Traders use conversion arbitrage to benefit from the potential differences that may occur in the prices of particular options.
Conversion is often considered a risk-neutral strategy because it includes both short put and long call that have a negative delta (-1) and a positive delta (1), respectively, meaning the strategy isn’t sensitive to price direction.
The trader buys a put and sells a covered call. Both options have the same strikes and expiration dates. The trader may profit when the call option is overpriced and the put is underpriced. This situation may occur due to market inefficiencies.
To put it simply - this arbitrage strategy enables traders to profit from small mispricings between calls and puts on the same underlying.
Implementing arbitrage in options trading may come with lower risk and may be profitable. However, it requires experience and advanced software that tracks price movements.
Therefore, if you want to improve your options trading, you should start by using an options-alert service, like FoolProof Options, to gain experience and upgrade your trading technique.
This options-alert platform may be very beneficial for your trading, as it will send you at least three alerts per week on options that are profitable. It costs only $97 per month and comes with many perks.