Arbitrage and Pairs Trading
AAA
  1. Pairs Trading: Introduction
  2. Pairs Trading: Market Neutral Investing
  3. Pairs Trading: Correlation
  4. Arbitrage and Pairs Trading
  5. Fundamental and Technical Analysis for Pairs Trading
  6. Pairs Trade Example
  7. Pairs Trading: Risks
  8. Disadvantages of Pairs Trading
  9. Advantages of Pairs Trading
  10. Pairs Trading: Conclusion

Arbitrage and Pairs Trading

At a basic level, arbitrage is the process of simultaneously buying and selling the same (or equivalent) securities on different markets to take advantage of price differences and make a profit. The price differences can be the result of market inefficiencies, pricing mismatches and even currency exchange rates. An arbitrageur, for example, could buy stock ABC for $50 on the New York Stock Exchange (NYSE), while at the same time, sell it for $51 on the London Stock Exchange (LSE), profiting $1 per share. Since arbitrageurs attempt to benefit from very small price moves, they typically must enter large positions to make substantial profits.

Before advancements in technology, it was possible for well-resourced arbitrageurs to capitalize on these arbitrage opportunities. Today the markets are a more level playing field, and as more people have real-time access to market data and with increased transparency, many of these pure arbitrage opportunities no longer exist.

While pure arbitrage is risk-free and based on actual pricing flaws, other forms of arbitrage are speculative in nature and based on perceived or implied pricing flaws: an investor’s perception that a price relationship has deviated from its historical average in a significant way. Pairs trading shares characteristics with two such types of arbitrage: relative value arbitrage and statistical arbitrage:

Relative value arbitrage
This type of arbitrage refers to simultaneous buying and selling of related instruments, whereby the trader’s profit depends on a favorable change in the relationship between the instruments’ prices. This type of arbitrage involves taking offsetting positions (long/short) in securities that are historically or mathematically interrelated, but where the relationship is temporarily misaligned. Investors can realize a profit when the relationship between the securities reverts to its norm.

Relative value arbitrage approaches involve several different investment strategies, including:

  • Capital structure arbitrage
  • Convertible arbitrage
  • Equity statistical arbitrage
  • Fixed-income arbitrage
  • Merger arbitrage
  • Options and warrants
  • Pairs trading.

Statistical arbitrage
Pairs trading can also fall under statistical arbitrage (“StatArb”), which is similar to relative value arbitrage. Relative value arbitrage and StatArb differ in terms of time frame, type of analysis and method of order entry. As relative value arbitrage, pairs trading can exist in almost any time horizon, using fundamental and/or technical analysis, and can be manually traded. Conversely, as statistical arbitrage, pairs trading exists in the very short term, relying on computer-driven modeling for analysis, and taking frequent trades (dozens or even hundreds each trading session) that are executed automatically by a computer (i.e., an automated strategy).

Pairs trading, then, has elements of both relative value and statistical arbitrage, and is, in fact, often referred to as either relative value arbitrage or statistical arbitrage. Regardless of how pairs are selected (either by fundamental or technical analysis), or how they are traded (manual-based or computer-driven), a pairs trading strategy is centered on the concept of mean reversion: that weakness in correlation can occur in the short-term, but will be corrected as prices revert back to the historical mean.

Fundamental and Technical Analysis for Pairs Trading

  1. Pairs Trading: Introduction
  2. Pairs Trading: Market Neutral Investing
  3. Pairs Trading: Correlation
  4. Arbitrage and Pairs Trading
  5. Fundamental and Technical Analysis for Pairs Trading
  6. Pairs Trade Example
  7. Pairs Trading: Risks
  8. Disadvantages of Pairs Trading
  9. Advantages of Pairs Trading
  10. Pairs Trading: Conclusion
RELATED TERMS
  1. Commercial Real Estate Loan

    definition of a commercial real estate loan
  2. Earnings Per Share - EPS

    The portion of a company's profit allocated to each outstanding ...
  3. Return On Investment - ROI

    A performance measure used to evaluate the efficiency of an investment ...
  4. Bidding Up - Securities

    The act of increasing the price an investor is willing to pay ...
  5. Bear Fund

    A mutual fund designed to provide higher returns when the market ...
  6. Mass Index

    A form of technical analysis that looks at the range between ...
  1. What is a common strategy traders implement when using the Parabolic Indicator?

    Learn a simple trading strategy designed for use with the parabolic SAR indicator, and understand the purpose for which the ...
  2. What are the best technical indicators to complement the Parabolic Indicator?

    Learn about two of the best technical indicators recommended for traders to use to refine a trading strategy based on the ...
  3. What is the Double Exponential Moving Average (DEMA) formula and how is it calculated?

    Discover the equation for double exponential moving average, or DEMA, and learn how it is calculated for a better understanding ...
  4. How do I use Mass Index for creating a forex trading strategy?

    Discover how forex traders can use Donald Dorsey's mass index to spot possible reversals in the price action trends of currency ...

You May Also Like

Related Tutorials
  1. Investing Basics

    Industry Handbook

  2. Fundamental Analysis

    Discounted Cash Flow Analysis

  3. Fundamental Analysis

    Ratio Analysis Tutorial

  4. The NYSE floor excitement after a rebound. Being a stock trader can be highly gratifying.
    Active Trading Fundamentals

    Introduction to Stock Trader Types

  5. Trading Strategies

    Top Investment Trends For 2013

Trading Center