How do I use the news to find arbitrage opportunities?

Traders can use the news to identify special arbitrage trading opportunities known as risk arbitrage. Two types of risk arbitrage are takeover and merger arbitrage, and liquidation arbitrage. Pure arbitrage trading involves traders attempting to profit from temporary market inefficiencies that result in the disparate pricing of investment assets across different markets or between various brokers. These temporary price inefficiencies present opportunities for traders to enact simultaneous buy-and-sell trades that lock in the profit inherent in the price differences.

Pure Arbitrage Trading

An example of pure arbitrage trading occurs when a temporary price discrepancy of a stock or other asset exists on different trading exchanges such as the New York Stock Exchange versus the Tokyo Stock Exchange. For such trading to be significantly profitable, institutional trading firms employ sophisticated software programs to detect and act instantly on arbitrage opportunities.

As a result, price discrepancies usually exist only very briefly and therefore require lightning-quick trade execution. Also, because the price discrepancies are very small, significant profits can only be realized by using large amounts of capital to multiply the profit amount. For these reasons, it is extremely difficult for individual retail traders to profit from pure arbitrage trading.

Risk Arbitrage

Retail traders do, however, have opportunities to engage in what is referred to as risk arbitrage. Risk arbitrage differs from pure arbitrage in that it involves risk, whereas pure arbitrage seeks to lock in a guaranteed profit the moment trades are initiated. But the risks involved in risk arbitrage are calculated risks that, when done correctly, can be tilted in the trader's favor. Keeping up with financial news and financial statements issued by companies can alert traders to various risk arbitrage opportunities.

Takeovers and Mergers

One risk arbitrage opportunity for traders occurs when there are potential corporate takeovers or mergers. The opportunity for profit is presented when a trader can identify an undervalued company that may be acquired or merged with another company, thereby bringing the company's stock price up to reflect its true intrinsic value. For example, if a company's stock is trading at $5 a share, but the actual value of the company is $8 a share, a trader can attempt to profit from an advance in the stock's price by purchasing the company's stock prior to the company being acquired.

Company Liquidation

Another type of risk arbitrage is known as liquidation arbitrage. As with merger or takeover arbitrage, the key to profiting from this strategy lies in correctly identifying an undervalued company that is likely to be liquidated. In the event the company's liquidation value is significantly higher than its market value prior to the liquidation, a trader can profit from the favorable difference in stock price.

Pairs Trading

A third type of risk arbitrage is pairs trading. The opportunity to profit from pairs trading is presented when two similar companies in the same business or sector have historically similar market values and trading patterns. When traders see a wide percentage variation in the price between the two companies, they sell the stock of the higher-priced company and buy the stock of the lower-priced company, anticipating that the relative prices of the two stocks will return to traditional levels.

In order to take advantage of these three types of risk arbitrage trading, investors will need to watch the news closely for signs that one of the scenarios exists or will be occurring in the near future.

(For related reading, see "Risk Arbitrage Trading: How Does It Work?")