I’ve worked for various trading companies and would like to share my experiences with arbitrage in this article.
As suggested by the headline, classical arbitrage involves taking advantage of price and interest rate differences in trading.
What are the different types of arbitrage?
We can classify arbitrage based on asset class, strategy and markets (spot market or futures market), but generally, all these types are very similar and can be assigned to one of the three categories:
- Pure (or “safe”) arbitrage, where traders have no risk and earn more than the risk-free interest rate.
- Near arbitrage, where two assets have identical or nearly identical cash flows but trade at different prices. Here traders have some risk because there’s no guarantee that the prices will actually converge.
- Speculative arbitrage, where traders try to take advantage of what they see as mispriced, similar assets by buying the asset they think is too cheap and selling the one they think is too expensive. At first glance, this might not be recognizable as arbitrage.
Many types of pure arbitrage aren’t visible to the naked eye. For this reason, traders use mathematical software and/or fully automated trading systems to take advantage of them. Another challenge is that many opportunities for pure arbitrage arise in smaller timeframes, and most manual traders are too slow to respond.
One example is index arbitrage, which I described briefly in the article “Fair Value” (German only).
Compared to other forms of arbitrage, pure arbitrage is rare and mostly found in the futures and options markets.
Let’s take a look at an example to help you understand the topic.
I’ll begin with a stock that’s listed on two stock exchanges — in this case, in Frankfurt and Paris. The prices quoted for such stocks often differ, especially for shares listed in Germany and other countries.
Here are the bid/ask prices for the stock XYZ on the Frankfurt stock exchange:
|Bid Vol||Bid Price||Ask Price||Ask Vol|
And here are the bid/ask prices for the same stock on the Paris stock exchange:
|Bid Vol||Bid Price||Ask Price||Ask Vol|
You face a small risk that the price difference between the two listings will suddenly become smaller, change in some other way, or that the volume in one market will decrease, making a hedge impossible.
What can you tell by looking at the two pairs of bid/ask prices?
The stock XYZ is quoted at 210.40/210.50 in Frankfurt. The same stock is quoted at 210.85/210.95 on the Paris exchange.
So, in relation to the price on the Frankfurt exchange, the stock is quoted approx. 35 cents too high in Paris. This means you can sell the stock in Paris, where it is quoted too high, and immediately afterward buy it back in Frankfurt, where it is quoted too low.
In our example, the arbitrageur would sell 528 shares at €210.85 and buy them back directly in Frankfurt for €210.50. Since there are only 528 shares on the ask on the opposite side of the trade in Frankfurt, the arbitrageur only sells 528 shares in Paris, not the entire 540 shares on the bid.
What profit would be booked excluding transaction costs, etc.?
Selling 528 shares at €210.85 and buying them back at €210.50 yields a profit of €0.35 per share. For 528 shares, this amounts to €184.80. Expressed as a percentage, the trader achieves a return of around 0.17 percent on invested capital (€184.80 / 528 shares x €210.85).
Situations like these don’t arise very often, and when they do, you might only earn €0.20 per share or less, but even that adds up by the end of the day. Professional arbitrage firms benefit from very good conditions and comparatively low transaction costs. For the retail trader, though, many trades aren’t feasible simply because of the high transaction costs. A final point is that nowadays, a lot of trading is done with the help of algorithms. Markets are scanned and traded automatically. This is another area where private traders lack the necessary infrastructure and expertise to compete.
American depositary receipts
Arbitrage profits can be made on stocks even if they don’t have a direct listing on a stock exchange abroad.
How does that work?
You can trade American depositary receipts (ADRs) on these stocks.
ADRs are similar to certificates and are issued by US credit institutions. Many represent a fraction of the stock; others are the equivalent of one full share. Their advantage is that they make foreign stocks easily tradable in the United States. They can be purchased like ordinary stocks, and the issuing financial institution determines the ratio of the ADRs to the underlying stock. A ratio of 10 means that 10 ADRs correspond to one of the original shares.
ADRs can be divided into three types:
- Level 1. This is the simplest type of ADR. These ADRs aren’t listed on an official stock exchange because the foreign company hasn’t qualified for a listing or doesn’t want to have one. Level 1 ADRs are traded over-the-counter (OTC).
- Level 2. These ADRs are traded on stock exchanges and must therefore meet more of the requirements set by the US Securities and Exchange Commission (SEC). As a result, they have significantly higher trading volume.
- Level 3. A Level 3 ADR program allows a foreign company to issue new shares in the US equity market and thus raise capital. These ADRs are followed more closely and have the largest trading volume compared to the other levels.
Example of near arbitrage with ADRs
I’d like to discuss a simple example of near arbitrage, in which there is always a degree of risk.
Let’s assume that the German company ABC wants its stock to trade in the US and instructs an American bank to issue ADRs. The bank sets a ratio of 10:1, with 10 ADRs corresponding to one share of ABC’s stock on its home exchange. The ADRs are currently quoted at $22 in the US. This means that the stock – to trade at a corresponding value – would have to be quoted at the equivalent of $220 in Germany after conversion from EUR to USD. If the stock is quoted at $219.50 after currency conversion, a trader could try to make an arbitrage profit by selling the ADR short at $220 and buying ABC’s stock back at $199.54 (the equivalent of $219.50 at an assumed exchange rate of 1.10). The profit would then be $0.50 per share less transactions costs. Because transaction costs are generally higher for ADRs than for normal shares, it’s only worth putting on an arbitrage trade if the price difference is big enough.
Spread trading (also known as pairs trading) is one form of speculative arbitrage. Although many see this as an independent trading strategy, I definitely put it in the speculative arbitrage category.
In spread trading you try to profit from a relationship or correlation between two different instruments. This form of arbitrage can be used in all markets and with all securities.
In other words, you bet that the difference between the two instruments will increase or decrease. For example, you can trade preferred shares against common shares, selling the share class that is quoted higher and buying the one that is quoted lower. However, it’s important to look at the historical spread and, if possible, only enter a spread trade when there are unusually large price differences (or extreme highs or lows). You can also trade different future contracts against each other (e.g. crude oil against WTI) or make spread trades with stocks from the same sector, such as E.ON and RWE. There are infinite possibilities. You should start by looking at markets, stocks, contracts, etc., that are normally correlated or historically similar, and try to profit from large divergences.
There are also many exotic spreads that are popular, even though the underlying assets are not strongly correlated.
At any rate, it’s definitely worthwhile for retail traders to familiarize themselves with spread trading. Many brokers offer margin discounts of 25 to 75 percent for spread trading in the futures market. This can be a real advantage, especially for low-capitalized retail traders. In addition, with spread trading, you aren’t dependent on market direction and the risk is usually smaller.
Conclusion on arbitrage trading
For professional and institutional traders, there are many ways and numerous strategies to money in the markets. One is arbitrage. For retail traders, though, it’s almost impossible to earn money through arbitrage due to transaction costs and the necessary expertise and infrastructure. The only form of arbitrage that can be of interest to retail traders is speculative arbitrage in the form of spread trading.
In my opinion, retail traders should concentrate on price action trading, where they are on a level playing field with professional and institutional traders.