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.
TradingProfiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
InvestingLearn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
TradingCovered interest arbitrage is a trading strategy in which an investor uses a forward currency contract to hedge against exchange rate risk.
InvestingThis influential strategy capitalizes on the relationship between price and liquidity.
InvestingWhile the opportunities are few and far between, investors may use arbitrage to take advantage of price differences in financial spread betting.
TradingRisk arbitrage provides a valuable trading strategy for M&A or other corporate actions eligible stocks. Investopedia explains how it works.
InvestingETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. But how does ETF arbitrage work?
TradingLearn more about this trade that profits from price differences between financal instruments and markets.
InsightsArbitrage betting is a method or system for exploiting differences in odds for profit.