DEFINITION of Time Arbitrage
Time arbitrage refers to an opportunity created when a stock misses its mark and is sold based on a short-term outlook with little change in the long-term prospects of the company. This dip in stock price occurs when a company fails to meet earnings estimates by analysts or its guidance, resulting in a short-term stumble where the price of the stock decreases. Investors like Warren Buffett and Peter Lynch have used time arbitrage to increase their chances of outperforming the market.
BREAKING DOWN Time Arbitrage
Time arbitrage is a long-term value investor's best friend. There are numerous examples of time arbitrage, but the regularity of earnings releases and guidance updates provides an endless stream of opportunities for Mr. Market to overreact to marginally negative news. Generally speaking, single misses do not mean a company is in trouble, and there is often a good chance of a rebound long term. However, if the misses become habitual, time arbitrage may actually be a losing proposition. The key is to have a good understanding of the company underlying the stock and its fundamentals. This will allow you to sort out the temporary dips that come from the market reaction from the actual devaluations that are caused by an erosion of the company's core businesses.
Time Arbitrage as an Options Strategy
Essentially, time arbitrage is another version of the old advice, "buy on bad news, sell on good." Buying a well researched stock on a dip is an excellent strategy as even the mega-cap stocks see significant swings in value throughout the year even though their five year trajectory is a stable increase in price. Buying on the dip is a straightforward way to get into a stock you want to own long-term. There are, however, other ways to make a time arbitrage play. One of the more interesting ones is to use options to buy a stock on a dip or profit when it fails to dip. An investor identifies stocks that he intends to own long-term. Then he sells a put on the stock. If the stock doesn't dip, meaning it continues to go up in value or stay above the strike price, the investor gets to keep the put premium and doesn't end up owning shares. If the stock dips to the strike price, the investor buys the stock at an even lower effective price as the option premium collected to date offsets some of the purchase cost.
The risk, of course, is that the stock falls far below the strike price, meaning that the investor ends up paying above market prices to buy the shares of the company he wants to own.