What are arbitrage trading strategies?

Arbitrage trading is an advanced approach that requires knowledge, confidence, and a deep understanding of markets. However, it’s a well-known technique used in forex, commodity, stock, and crypto markets, so it’s worth learning. 

Arbitrage is represented by many types of strategies. Below, you will find the concept that relates to the financial markets the most. 

What is arbitrage?

The idea of arbitrage trading is to gain rewards from the price difference between a single asset traded on different markets or in different forms. It can also be applied to the price differences between related financial instruments. A trader buys an asset for a lower price and sells it for a higher price on another market simultaneously, benefiting from tiny price differences.

This technique goes against the “law of one price.” It’s an economic concept that claims that the price of a single asset has the same value around the world, regardless of location, when certain factors are considered.

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Arbitrage isn’t supposed to be a highly profitable strategy. The size of the rewards depends on the difference between prices. Therefore, a trader should look for a significant price divergence so rewards outweigh risks. 

Arbitrage is often called “risk-free.” However, you should understand that there is no risk-free strategy. Any trading approach implies risks of wrong price predictions and capital loss.

There are numerous arbitrage techniques. Below, you will find a definition of the statistical arbitrage trading strategy and its types. 

Statistical arbitrage trading strategies

Statistical arbitrage, also known as “stat arb,” was created in the 1980s when Morgan Stanley’s equity block trading desk needed a hedging strategy. The trading desk purchased many stocks in one company and sold closely-correlated stocks of another company to hedge investments against enormous market fluctuations. 

Later, traders transformed this “pairing” into one strategy that allowed them to gain from price differences. As a result, traders can take advantage of statistical price differences caused by liquidity, risk, volatility, or other fundamental and technical reasons.

An example will make the explanation easier. Shares of The Coca-Cola Company and PepsiCo usually move similarly. If you notice a divergence in their price movements, this may be a sign of a temporarily exploitable opportunity. 

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It’s believed that the divergence will last for a short term, as, usually, the shares move in the same direction (mean reversion). To apply the statistical arbitrage approach, you should buy the declining stock and sell the one that rises. A trader hopes for the prices to converge again. 

The statistical approach includes several trading strategies, including risk arbitrage, high-frequency trading, neural networks, and volatility arbitrage.  

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Volatility arbitrage trading strategy

This is a strategy based on the assumption of the size of the upcoming volatility. A trader should be able to project an upcoming volatility degree of the underlying asset and find the one whose current volatility is either lower or higher. Numerous fundamental factors can cause the difference in volatility. For the stock market, they include uncertainties around earnings reports, merger and acquisition speculations, and patent disputes. 

If a trader believes the current volatility of an asset is underestimated, they open a buy trade for the call and sell the underlying asset to hedge. As a result, the trader’s portfolio becomes delta neutral. The trade is considered successful with the unchanged stock price when the implied volatility rises, and the asset reaches its fair price. 

You can use the inverse rules for the overestimated asset, selling a calland buying the underlying asset. 

The strategy implies risks related to the wrong assumption, whether the asset is over- or undervalued, the timing for holding the positions, and the change in the underlying asset’s price.

Takeaway

Arbitrage trading includes numerous types and strategies. You can apply this technique to numerous markets. Therefore, first, you should determine what assets you want to trade. Second, you need to determine which approach works the best. Only after that should you try trading using divergence in prices.  

Disclaimer: No strategy can guarantee a 100% correct trade outcome.

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