How Does Arbitrage Trading Work?

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There is no language in the world that contains as many dreary words as the world of finance.

Capital asset pricing models, purchasing power parity indices, gross domestic product…aggregate demand and supply. You can feel the blood draining from your face as you read them.

Yep, they all mean something. But let’s face it. They will never match the intimate language of a TS Eliot, or other love-struck poets.

You can only pity the poor souls who have to edit finance books. No person with a beating heart could ever possibly read one in a single sitting.

Amongst the drudge, though, there are some exotic words. Some that might even sound a bit exciting. That conjure up a hint of mystique.

One of those words is ‘arbitrage’.

It sounds exotic, not only because of its French, and prior to that, Latin origins. But also because of what it represents.

Arbitrage is the very thing of which every trader dreams. That is, the chance to profit without taking on risk.

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Can you ever eliminate risk when trading?

Of course, mitigating or limiting risk is one of the goals of any trader. And if it isn’t…it should be.

Risk calculation forms the basis from which you can more accurately calibrate the potential reward for any trade.

Arbitrage is the simultaneous buying and selling of the same asset or commodity, at different prices. That is, you sell the asset at a higher price in one location, at the same time you buy it for a lower price in another.

Your only limit is the volume available, and the size of your pockets.

It represents a risk-free profit, and is finance’s version of perpetual motion. A trade that generates profit, without any net input, or risk.

There is also something else, which needs to be in place, before arbitrage can exist. That is, an inefficient market.

If all markets were efficient — and thereby always trading at their true (or fair) value — no avenue for arbitrage would exist. The same assets would always trade at the same price.

Part of that has to do with the above mentioned market efficiency. If a discrepancy existed, algorithms from the huge trading houses would quickly identify and eradicate them. Meaning that they would keep buying and selling the same asset until restoring parity.

The other reason, though, is that most assets are not exactly the same. Even if you might think they are.

For example, BHP Group Ltd [ASX:BHP] is listed on multiple exchanges. Shares can trade at significantly different values on each.

The ASX-listed BHP has traded upwards of 15–20% higher than BHP shares listed on the London Stock Exchange.

Some tax, some structural

While BHP shares on both exchanges own the assets and future cash flows of BHP, they are not exactly the same.

Part of that has to do with franking credits. BHP dividends paid in Australia come with franking credits. It was this huge pool of franking credits that attracted the interest of activist shareholder, Elliott Group.

But it is also more than that.

Passive funds, like index ETFs, need to buy shares as per their weighting in their index. The bigger the weighting, the more shares they need to hold.

With BHP representing a bigger weighting in Australian ETFs than their counterparts in the UK, that’s another reason for the discrepancy. Put simply, Australian-based ETFs need to hold a bigger proportion of BHP than those in the UK.

Plus, there is speculation behind the different currencies — the British Pound and the Aussie dollar — that also drives some of the mismatch.

Perhaps one of the few markets left where arbitrage still exists — albeit momentarily — is the FX market.

It can involve trading between three or more currencies, to multiple decimal places, to generate a profit. That’s perhaps beyond the scope of a private trader.

More than one way to arbitrage

Arbitrage, though, sometimes takes on a meaning beyond its basic definition. It can involve indices, and the weighting of shares in them.

But again, private traders should not get their hopes up. It is the domain purely of the big institutions and their algorithmic traders.

The aim is the same. That is, to profit from different pricing. But this time, using different underlying assets.

So how does it work?

Given an index price, a computer can quickly calculate the fair value of each share in that index. That’s because it already knows what each weighting should be.

Similarly, if the computer knows the prices of all shares in the index, it can calculate the fair value of the index.

The aim is to take advantage when a mismatch occurs.

The algorithm buys or sells index futures contract, while buying or selling the stocks (or a replica of the stocks) in that index.

In other words, buying stocks (or the index) when they are trading below fair value. And, short-selling stocks (or the index), when trading above fair value.

It involves multiple, lightning fast trades, which requires enormous computer firepower. And a big bankroll.

But there is a way private traders can participate. And again it might not technically be arbitrage.

It also uses indices and stocks…but in this instance, their re-balancing.

If a stock joins an index, ETF funds that replicate that index will have to buy those shares. It’s not a choice — it has to match the index. What they cannot do is buy them in anticipation of it happening.

By buying into a stock they believe will join an index, a trader can profit when ETFs have to add those shares to their holdings when the index rebalances. By buying in, they will typically drive up the price.

Similarly, for every stock added, one must come out of the index. A trader could short-sell those shares. Or if available, buy put options to try to profit when index funds offload their shares.

While arbitrage might be difficult for private traders, it doesn’t mean it is impossible. As index re-balancing highlights.

But this difficulty is a good thing.

If arbitrage were easy, it would mean that markets are highly inefficient. And while markets will never likely be fully efficient, arbitrage keeps the markets as close to efficient as they can be.


Matt Hibbard,
Editor, Options Trader

PS: In this just released report, Matt Hibbard shows you his top five dividend picks for 2019. Click here to claim your copy today.

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