When it comes to investment tactics, there are plenty of options to choose from. The most popular is what it is called “going long” where people buy a certain set of stocks and hold them waiting for earnings in the long run. However, there are alternative strategies that can be more effective than these but are also a little bit more complicated.
Among these alternative tactics, we find arbitrage. This alternative is extremely profitable when it is employed correctly. Because of this, experienced investors prefer this method over more “long run alternatives. The tactic is not suitable for beginners as there are a lot of risks involved which can grow exponentially if you are not well-versed in what you are doing. Before jumping into this pool, you need to understand how deep it is to swim (or dive) with confidence.
If you want to know what this is all about, you are in the right place. We’ll be doing deep dive into the world of arbitrage to explain everything you need to know about this technique.
What is arbitrage?
As we have stated before, this is an investment strategy that involves an investor buying and selling the same asset. The idea is to do this in different markets, hoping to generate a profit thanks to the price difference in both markets. The difference in price between markets is usually small, but when you consider a big volume of operations, returns can be considerably greater, making this a viable option for investments.
Different types of arbitrages can exist and can be used. The most common ones are known as pure arbitrage, merger arbitrage, and convertible arbitrage. There are other investment strategies like Global macros that are not entirely contained within the realm of arbitrage, but that can be considered as well when looking for a viable investment option.
Types of arbitrages
Let’s see in detail what are the different types of arbitrage strategies that you can use with the hopes of bringing a profit.
1. PureArbitrage
Pure arbitrage is one investment method that involves an investor buying and selling security in different marketplaces at the same time while looking to profit from the price disparities that might exist. As you can see, this matches the definition that we have mentioned before for arbitrage, therefore the terms arbitrage and pure arbitrage are used interchangeably and their meaning is the same.
Different markets offer the ability to buy and sell different investments. Because of this, there is a good chance that prices can change at any given time, creating a price divergence where performing a pure arbitrage operation is ideal.
Another option is to perform a pure arbitrage operation when there are currency exchange discrepancies that can open the door to these types of operations.
However, on the downside, we have to mention that because of technological improvements, opportunities to perform pure operation arbitrations are less frequent. This is because any price disparity can quickly be identified and corrected, therefore this type of operation has become less and less common.
2. Merger Arbitrage
This type of operation deals with merging entities, for example, two companies that are publicly traded. A merger involves two entities, the acquired company, usually called target, and the acquiring company. When the target company is traded publicly, the acquiring company is required to purchase the majority of the shares of the company.
The majority of the time, this is at a premium to the stock's market value at the announcement, which benefits shareholders. The stock of the target firm is bought by investors hoping to profit from the deal as soon as it is made public, bringing the price closer to the deal price.
In its simplest form, merger arbitrage happens when a shareholder buys shares of the target business at a discount to profit after the deal closes. However, merger arbitrage takes different forms. An investor may decide to short shares of the target company's stock if they think a deal will not go through or succeed. This strategy requires strong knowledge as there are potential risks that might generate losses if the investor is not careful.
3. Convertible Arbitrage
This type of arbitrage is related to convertible bonds. It is usually called convertible debt. Essentially, a convertible bond is the same as any other bond: it is a type of corporate debt that pays interest to the bondholder.
A convertible bond and a standard bond vary primarily in that the former gives the bondholder the opportunity to convert the bond into shares of the underlying firm at a later time, frequently at a discounted cost. Convertible bonds are issued by companies in order to provide lower interest payments.
Convertible arbitrage is the practice of investing in bonds with the goal of profiting from the discrepancy between the conversion price and the current share price of the underlying firm. Usually, this is accomplished by opening long and short positions in the convertible note and the underlying firm stock at the same time.
The power of arbitrage for the investor
This is definitely an efficient instrument for investors looking for low risk yields in the arbitrage technique. High volumes are necessary to fully benefit from arbitrage and make enough money to cover transaction fees because yield is frequently low. Because of this, arbitrage is typically not a tactic that regular investors can use to their advantage. Even though it is considered a low-risk yield, the risks are there and important to consider, especially for beginners.
Disclaimer: This article is provided for informational purposes only. It is not offered or intended to be used as legal, tax, investment, financial, or other advice.
