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.
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.
A broad definition for three types of arbitrage that contain ...
An investment strategy that attempts to profit from arbitrage ...
A profit situation arising from pricing inefficiencies between ...
The simultaneous purchase and sale of an asset in order to profit ...
An opportunity created when a stock misses its mark and is sold ...
An options trading strategy employed to exploit the inefficiencies ...
Learn what risk arbitrage trading is and how this type of arbitrage trading opportunity is available to individual retail ... Read Answer >>
Understand what arbitrage trading involves and what the necessary skill set is that a trader must develop in order to master ... Read Answer >>
Learn about different types of arbitrage models and techniques, and discover why classic arbitrage opportunities are very ... Read Answer >>
Understand the meaning of arbitrage trading, and learn how traders employ software programs to detect arbitrage trade opportunities. Read Answer >>
Investing money can be confusing for novice investors. Find out more about covered interest arbitrage and the risks that ... Read Answer >>
Dive into two very important financial concepts: arbitrage and hedging. See how each of these strategies can play a role ... Read Answer >>