Arbitrage can be viewed as a deal where there is no existence of a negative cash flow whether in a probabilistic state or temporal state. There is positive cash flow as per opinion in minimum one state. It is simply a risk free profit or gain.
Definition of Arbitrage
Purchase of securities for example; stocks, bonds, commodities as well as currencies or foreign exchange, on one market in order to sell it immediately to another market to profit from a price discrepancy is the purest form of arbitrage. Instant risk free profit is the result of this. The price of a security on NYSE for example is trading out of sync with its corresponding futures contract on Chicago exchange; a business man may buy the less expensive and sell the two more important hence profit on the difference. Three conditions will be violated in this case: one, on all markets the security must sell on the same price, two; two securities of the same cash flow must trade at a similar price. Arbitrage can take other forms: the first form is, risk arbitrage or statistical arbitrage. Risk arbitrage is one of the most popular forms of arbitrage though considered speculation.
Market makers and true arbitrage
Generally market makers have more advantage over retail traders. e.g.; more skills, faster computers, more trading capital, this advantage reduces competition from retail traders to almost zero. With the help of their advanced computers market makers identify this opportunities and take advantage of them. Since they have enough capital they make the transaction which is completely risk free.
Definition of Arbitrage
Definition of Arbitrage
Retail traders and risk arbitrage;
Retail traders play the odds by trying to take advantage of risk arbitrage which involves taking some risk. To explain the risk involved in risk arbitrage lets take the example of an undervalued company being targeted by another company to take over a bid. This bid is supposed to bring the company to its true value. If the company is taken over and a success is achieved then those who took advantage of the opportunity benefit, however if the takeover fails then, the companies also make losses. Speed is the key to making market success in this form of arbitrage. Utilizing this method helps trader trade on level two and has access to streaming news Definition of Arbitrage
If you are not among the first traders to make deals to benefit from arbitrage, how do you know it is still safe to make a deal. Lucky for those traders Benjamin graham came up with an equation for them to use;
Annual return = CG-L(100%-C)/YP; where C=expected chance of success in percentage. P=to the current price of security. L =to the expected loss incase of failure. Y=the expected holding time in years. G is the anticipated profit if all works out.
This formula will give you an estimated idea of what to expect if you get in to a merger.
Risk Arbitrage: Liquidation Arbitrage
This form of arbitrage involves estimating the value of liquidated assets of a company. Gordon Gecko employed this type of arbitrage when he bought and sold off companies. If a company for example is trading its shares at $7 while its liquidated value is worth around$10 share. If the company decides to liquidate the assets it presents a an opportunity for arbitrage.
Risk arbitrage: pairs trading
Pair trading is also known as relative-value arbitrage. This form relies on a strong correlation of two unrelated or unrelated securities. As a way of profit making it is primarily used during sideways. Finding pairs is the first step in this kind of arbitrage high probability pairs typically are large stocks in the same industry that have the same long term trading histories. A high percent of correlation is something to look out for. A divergence of 5-7%that lasts for a period of 2-3days and more is waited for. Based on the comparison of their pricing you can finally long and/or short, then wait for the prices to come back together. An example of these is the security used in pairs trade is General motors and Ford. The two have a 94% correlation. By plotting this two securities and waiting for a divergence that is significant. These two prices are likely going to return a higher correlation.
How to find arbitrage opportunities
There are many ways to find these opportunities because this information is found in tools available to anyone. Brokers are the first tool; they provide news wire services the minute an opportunity comes up. Another option for acquiring this information is level 2 trading which can also give you an edge. Screening software is also another option which can help you identify undervalued securities. Also available are several paid services which locate arbitrage opportunities for you. These services are very useful for pairs trading. This can involve better efforts in finding correlations between securities. These services send daily reports of opportunity or weekly spreadsheet.
Arbitrage is wide and encompasses many strategies but all of them seek to take advantage of increased success chances. Retail traders cannot indulge in pure arbitrage which is risk free but there are many other forms of arbitrage they can take advantage of and make good profit.
Other types of arbitrage are: exchange-traded fund arbitrage, convertible bond arbitrage, municipal bond arbitrage, regulatory arbitrage, depository receipts, triangle arbitrage telecom arbitrage and statistical arbitrage.