## Wednesday, April 30, 2008

### Classical Arbitrage Strategies Explained

Now that I have described pair trading, the next topic of interest lies in “risk-free” arbitrage strategies. Due to generally limited literature, this subject remains heavily veiled behind institutional trading.

Classical arbitrage defined

Classical arbitrage applies to any business strategy where one exploits market inefficiencies for a risk-free, self-financed profit. Discrepancies in offered values of same underlying commodities/services present the said “market inefficiencies”.

I had provided some examples a while ago on the blog. They present some direct and practical business models or trading schemes applied by real life people.

Are they really entirely risk-free?

No, but it takes much less effort to control the risks arbitrage strategies face, as profitable trades occur regardless of market movement or volatility exposure. In other words, common risks associated with naked stock positions disappear.

Liquidity, price impact, and transaction costs (associated with transaction sizes) generally become manageable via adequate calculations. Mathematical finance helps to optimize arbitrage strategies via things like linear programming or vector space representations, but to become basically profitable (just not maximized), anyone with basic algebraic understanding can manage it.

Do you need huge capital to apply arbitrage strategies?

No. Many opportunities exist for traders of all levels of account sizes. Though of course the larger the trades, the more insignificant transaction-costs become which makes rewards more attractive.

Quick example:

A NZ company is listed on both the NZSX and ASX, and today at close you see the following prices for the stock:

(Hypothetical prices)

· At NZSX: \$10.00NZD/share

· At ASX: \$10.50NZD/share

You sell 300 shares short on the ASX (requires \$3,150 cash in account), then buy 300 shares of the stock long on NZSX. When prices converge you close both positions.

· Total initial cash requirement: \$6,300

· Total profit: \$150

· Total transaction cost (at \$30/trade): \$120

· Total net profit: \$30

At \$30/trade, the brokers here charge way too much, hence making arbitraging in this manner not-so-attractive.

So, with a few thousand dollars, anyone can make money in these markets regardless of market movement.

Reasons why not all traders apply these strategies

Some simply do not understand it or never bothered looking it up. Then for others, the returns remain too low. While arbitrage strategies offer double digit returns per year with very low-risk, ambitious traders aim for much higher targets.

Exceptionally high returns require strategies of highly active management and innovation. Though once found, the mentioned arbitrage models do not look attractive anymore. I have met traders who make over 1% per day, consistently, so yes it is all possible.