Now that I have described pair trading, the next topic of interest lies in “risk-free” arbitrage strategies. Due to the generally limited literature, this topic remains largely hidden behind institutional trade.
Definition of classical arbitration
Classic arbitrage applies to any trading strategy where market inefficiencies are exploited for a risk-free, self-funded profit. Discrepancies in the offered values of the same underlying products / services present such “market inefficiencies.”
I had provided some examples a while ago on the blog. They present some direct and practical business models or business schemes applied by real life people.
Are they really risk-free?
No, but it takes much less effort to control the risks faced by arbitrage strategies, as profitable trades occur regardless of market movement or exposure to volatility. In other words, the common risks associated with naked stock positions disappear.
Liquidity, price impact, and transaction costs (associated with the size of transactions) are generally made manageable through proper calculations. Mathematical finance helps optimize arbitrage strategies through things like linear programming or representations of vector spaces, but to make them basically profitable (but not maximized), anyone with basic algebraic knowledge can manage them.
Do you need a lot of capital to apply arbitrage strategies?
No. There are many opportunities for traders of all levels and account sizes. Although, of course, the larger the operations, the more insignificant transaction costs become, which makes the rewards more attractive.
Quick example:
A New Zealand company is listed on both the NZSX and the ASX, and today at closing you will see the following stock prices:
(Hypothetical prices)
In NZSX: $ 10.00 NZD / share
In ASX: $ 10.50NZD / share
Sell 300 shares short on ASX (requires $ 3,150 in cash on account), then buy 300 shares short on NZSX. When prices converge, you close both positions.
Total initial cash requirement: $ 6,300
Total profit: $ 150
Total cost of the transaction (at $ 30 / operation): $ 120
Total net profit: $ 30
At $ 30 / trade, the brokers here charge too much, so arbitrage is not that attractive.
So with a few thousand dollars, anyone can make money in these market-moving markets.
Reasons why not all traders apply these strategies
Some just don’t get it or never bothered to look it up. Then for others, the returns are still too low. While arbitrage strategies offer double-digit returns per year with very low risk, ambitious traders aim for much higher targets.
Exceptionally high returns require very active management and innovation strategies. Although once found, the aforementioned arbitration models no longer seem attractive. I have known traders who earn more than 1% per day, on a consistent basis, so yes, anything is possible.