Risk Reduction Using Arbitrage

The first question we often hear when talking about arbitrage is, "What is that?"

Simply put, arbitrage is when an investor finds the same asset for sale for different prices. To make money on this, the investor buys the asset at the lower price and simultaneously sells it at the higher price.

When speaking with a client, I often use the following analogy. Imagine that your local Wal-Mart is selling single eggs for 10 cents each. Later, you find out that the local Baker is buying the exact same brand of eggs for $2 per dozen. Someone who wants to make money on this situation could buy the eggs for $1.20 and then sell them to the Baker for a profit of 80 cents ($2 - 1.20=$0.80). It is also possible to do such a trade in the opposite direction if cartons are cheaper than buying the eggs one by one. Simply buy the carton, break it up and sell the eggs one at a time

Pure arbitrage is a risk-free strategy. This might happen if a stock sells on two different exchanges and one of them has a lag. Unfortunately for the typical investor, the Wall Street trading firms already have computer programs in place that snap these opportunities up within milliseconds of them developing. The good news is that other opportunites for arbitrage do still exist.

One of them involves the ETF markets. ETFs are Exchange Traded Funds. They are like a hybrid of a stock and an index fund. Like an index fund, they invest in a fixed basket of investments. The contents of this "basket" are available for any potential investor to examine. Like a stock, they trade on the open market instead of being issued and redeemed by the fund manager like mutual funds are.

When the price of the ETF is different from the actual value of the investments it owns, our investors can make a profit. This is like our example of buying eggs one-by-one and selling them by the dozen to bag a riskless profit.
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The discussion in this post is intentionally general in nature. The above strategy might introduce small to moderate levels of liquidity risk. For information regarding arbitrage opportunities in the current market, email us here.