Arbitrage 101
WTF is Arbitrage?
If you’re deep into the world of investing or trading, you’ve probably heard the term arbitrage before, but it’s a concept and strategy that escapes most market participants. Given its relative complexity in terms of execution, it’s not that surprising to see that be the case for the average retail trader, but the actual concept of arbitrage is not particularly complex, especially when you frame it in terms of real-world examples, which I will certainly get into.
To offer a basic definition, arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price. There are other examples of arbitrage I will get into that, admittedly, demand a second definition, but this remains a good starting point. The reason it’s a good starting point is it is the type of arbitrage, by and large, you will hear referenced.
When there are differences in prices for the same asset listed in different markets, there’s an opportunity for traders to buy from one market and sell into the other to make a quick profit. This process is actually what keeps prices of the same asset across markets relatively equal. If the price differences get out of hand, arbitrageurs trade it until the spread disappears.
PRICE ARBITRAGE
The most basic form of arbitrage in financial markets and the form referenced in the previous definition is price arbitrage. When an asset like gold is listed on several different exchanges, there are often slight differences between those prices throughout the day that can be captured by traders. If gold on one exchange is selling for $1,800 per oz and on another exchange selling for $1,810 per oz, an arbitrageur can quickly buy gold on the first exchange and sell it on the second to make a guaranteed $10 per oz.
As alluded to earlier, this process is how assets hold price parity across all the different markets in the world. As long as assets are worth more on certain exchanges or in certain areas of the world, there is an arbitrage trade to be made and those trades will continue to be made until that spread tightens. For this reason, arbitrage is an essential element of a healthy market as it is one of the main reasons assets maintain a universal price.
Example:
I’ve already briefly touched on an example of price arbitrage with gold listed on different exchanges, but let me outline a slightly more advanced example common in financial markets today.
In most developed markets, there exists both a spot and futures market—the spot being the actual asset like oil, Bitcoin, Nasdaq, or the like, and the futures being a derivative of that asset that allows for easier/faster settlement with more liquidity and leverage. The specifics of what each market is don’t really matter for this example, just know their prices are near-perfectly correlated and tied to the same asset.
When the spot price of an asset, such as Bitcoin, trades below its futures price, arbitrageurs will step in to buy spot Bitcoin and sell an equal amount in futures contracts to pocket the difference as the two prices converge. And if the price of Bitcoin trades above its futures price, they will buy the futures contracts and sell spot to accomplish the same thing.
These price differences between what are essentially the same assets create a tightening pressure at the hands of arbitrageurs to close the price gap. If this is for an asset like oil that has the cost to carry and deliver it added into its value, the prices won’t usually converge all the way, but for an asset like Bitcoin or Nasdaq, where there are no costs associated with holding or settling it, the price differences should, in theory, come close to parity.
Flash Loans
Another fascinating element in the price arbitrage game and one of the coolest additions to the arbitrageur’s arsenal that has been made possible in recent years is flash loans. These are instant loans that require zero collateral. The only catch is they have to be paid pack within minutes or even seconds (usually until the end of the current block as they are predominately a DeFi product). Now, you might ask yourself how that would be useful, but with algorithmic trading, you can take out flash loans to instantly lever up on an arbitrage trade to maximize your profit and return that loan within minutes after the trade is complete and you’ve made your money.
Aside from the obvious leverage advantages flash loans offer, what makes them particularly special has to do with the fact that price spreads in the world of arbitrage are incredibly small and, thus, somewhat pointless to the average trader. When price differences are just a few dollars or even cents, most retail traders can’t trade with enough size to make the spread gained worth their while, but flash loans change that. If the price difference between gold on two exchanges is $1, you would need almost $20,000 just to make $10 on that trade, which is hardly worth it even if you have $20,000 to trade. If, however, you had access to a flash loan, you could take that same trade with a $400,000 loan to make a quick $200. You don’t need to post any collateral to qualify for that big of a loan because it’s repaid so quickly, but you get all the benefits of essentially risk-free leverage.
That being said, executing such a trade requires a certain level of expertise and isn’t advised if you don’t know exactly what you’re doing. Flash loans are a great way to expand the world of arbitrage to the retail or undercapitalized cohort, but they aren’t exactly part of an entry-level trade, so remain cautious if you plan on diving deeper into that world regardless of how easy or cool it sounds.
LOCATION ARBITRAGE
The next type of arbitrage is location arbitrage, which occurs when someone profits from the spread between the price of an asset in one location and its price in another. Markets and market prices vary quite a bit even on a local scale, so there is always an opportunity to buy something in one location—even if that’s just down the street—and sell it in another location for a significantly higher price.
Example:
One simple example of location arbitrage we’d all be familiar with is buying gas or grocery items at cheaper locations. Though most people don’t resell any of those items when they buy them cheaper, they are still pocketing that spread between the prices at the different locations and could potentially resell them for a profit if they really wanted to.
Another familiar example would be alcohol at a concert selling for twice the price it usually does. That venue or organization using the venue buys a bunch of beer and liquor at one price and then sells it to the concertgoers at what is usually a pretty disgusting premium—but hey, you’re not not gonna get drunk, amiright?
Most people probably don’t know this practice by the name arbitrage, but instances where someone resells an item for a profit are usually a form of arbitrage. Plenty of small businesses that buy from Costco—or any middleman for that matter—engage in this exact kind of arbitrage all the time by purchasing goods in bulk for cheap and then reselling them at a premium.
This kind of location arbitrage is arguably the oldest form of arbitrage as it’s how many merchants and traders made a living long before the modern era of economics. These traders would buy goods in their local town and travel to a distant town where they could sell them for a higher price. It’s a simple but effective way to make money off the different supply and demand dynamics within each market.
Labor Arbitrage
Another important example of location arbitrage that is very relevant to modern economies is labor arbitrage. This is when companies buy labor in other countries where wages are low and then sell the products those cheaper laborers make in other countries (often their own) where wages and goods are higher in price.
Example:
A prime example of labor arbitrage is all the American companies transitioning their manufacturing over to China where labor and other costs are lower so they can make more money when they sell those products back to the American citizens. By making this transition and buying cheaper labor in China, they capture the spread between American wages and Chinese wages. It should be noted, however, though labor arbitrage is frequently referenced within the context of globalization and expansion to cheaper foreign labor markets, it can occur locally as well—it just probably won’t offer as large of a spread for businesses to capture.
TIME ARBITRAGE
The last form of arbitrage I wanted to discuss is time arbitrage. Time arbitrage is the process of buying an asset at present under the notion its expected value at a later date is to be higher given some near-guaranteed event like a buyout or merger.
Like with all arbitrage trades, time arbitrage capitalizes on a price spread. In traditional price arbitrage, that spread is the difference between the same asset at another location or on another exchange, but time arbitrage profits through the spread between the current market price and the fixed future value. That could sound a lot like just buying a stock and waiting for it to go up in value, but what makes it different is the perceived certainty of that future value based on some proposed deal.
Investors and traders can have good reason to believe an asset will appreciate, but that doesn’t make it arbitrage. When there is a deal on the table offered by a company or made between multiple companies, however, the future value is all but guaranteed by that deal coming to fruition. There are more risks in time arbitrage than in traditional arbitrage as the deal guaranteeing the price could fall through, but there is often a clear spread between the trading price and the potential future price that paves the way for an arbitrage trade.
Example:
Before I get into the weeds with the examples in financial markets, let me give an everyday example of time arbitrage: the reselling of tickets. When someone buys a ticket for a popular concert or sporting event with the intention of selling it later for a higher price, they are engaging in time arbitrage. Although all the tickets sell for the same price in the beginning, if the show or event ends up being sold out and someone is willing to pay more than the original price to go, you can pocket a sizable spread between the original price and whatever people are willing to pay leading up to the day of the event. This doesn’t have the same concept of a deal being made or a specific future price as most time arbitrage cases do, but it’s still a way to capture a spread simply by waiting for some amount of time to pass.
As for examples of time arbitrage in the financial markets, there are five specific kinds I want to discuss in some detail: friendly mergers, hostile takeovers, corporate self-tenders, liquidations, and spin-offs.
In all these examples, the level of uncertainty around the future fixed value will generally determine the spread. The more likely the market sees the expected future value to become a reality, the tighter the spread will be between it and the current trading price. Conversely, the less likely the market sees that future value to be borne out, the wider the spread will be. In other words, the spread is usually dependent on how risky the proclaimed deal guaranteeing the future price is, and as the deal draws closer to being actualized, that spread will tighten until it eventually converges with the expected future value.
Friendly Mergers
Friendly mergers are when two companies mutually agree to a buyout. This is usually based on some assumption each company has something the other wants or needs, so the likelihood of the merger happening is very high. The relatively low risk of merger deals falling through given the mutual interest, however, generally means the spread between the trading price and the expected buyout price will be much smaller or even nonexistent by the time you find out. There still should be a chance to arbitrage the difference from the time of the announcement, but the spread will most likely completely disappear leading up to the actual day of the merger.
A helpful tip just in case you were wondering how to go about trading mergers and acquisitions is you want to buy the company being swallowed. If company A is doing the buying/swallowing, you would buy 1 share of company B and short the number of shares company A is offering for that share of company B. Then on the closing day of the merger, you would exchange your company B share for the shares company A is offering and use those shares to cover your short on company A, thereby locking in the spread difference. Whatever the specifics of the merger may be, you can apply this logic and the appropriate share ratio to match the specific circumstances and, hopefully, make a solid, low-risk trade.
Hostile Takeovers
Hostile takeovers are when a buyer (oftentimes a company) buys a controlling interest in another company against that company’s will. It is not a mutually agreed upon buyout, hence the term hostile, but can still go through for the right price because of various fiduciary responsibilities companies have to their shareholders. Nevertheless, with a controlling interest, the buyer is essentially in charge of how the company is run—but to get that controlling interest they usually have to place a bid well above the market price, and the difference between that market price and the hostile takeover bid is the spread traders can arbitrage.
After a hostel bid is made, the market will decide how likely it is to happen and try to price accordingly, which could mean it shoots directly up to the bid price or anywhere in between depending on how spurious the takeover bid seems. The likelihood of the takeover happening (or the spread available to capture) often rests on how the buyer attempts to accomplish it and how well all the pieces align within that takeover method.
When a buyer decides to engage in a hostile takeover, there are three avenues they can take:
1. Get the target company’s board to approve the deal.
2. Get the support of a majority of shareholders to vote and replace the board.
3. Go into the market and buy the necessary shares to replace the board on their own.
As I’m sure everyone has already heard by now, Elon Musk attempted a hostile takeover of Twitter via avenue #3. However, Twitter tried to thwart that plan through what is known as the poison pill defense. This defense gives the current shareholders an opportunity to buy additional shares at a discount, which dilutes the per-share value of the company and, as a consequence, increases the cost to the hostile buyer, in this case, Elon.
I mention all this because that information would all be very relevant to anyone looking to arbitrage Twitter shares as it all increases or decreases the likelihood of Twitter shares eventually being worth $54.20, Elon’s bid price. If shares are trading at $47 right now, you buy them, and the deal goes through, you would make $7.20 per share, but it’s also possible you lose money if the deal doesn’t go through. If the current price isn’t trading at $54.20, it’s probably because the market still believes there is a chance the hostile takeover falls through, in which case Twitter shares would likely fall to their trading price before the hostile takeover was announced, if not further.
Unlike regular price arbitrage, there is significant risk in hostile takeover arbitrage due to the inherent uncertainty, so it’s important to make a calculated bet based on your assessment of how probable the takeover actually is. There are a lot more factors and uncertain variables in hostile takeovers than most other arbitrage trades—the Elon/Twitter takeover being a good recent example—that should always be a part of your risk calculation no matter how appealing the potential spread profit is. Remember, the spread is only captured if the deal goes through.
Corporate Self-Tenders
Corporate self-tender offers are just an alternative to share buybacks. But rather than buying shares on the open market, the company makes a tender offer directly to shareholders, meaning they buy their shares from that at a premium. Usually, when these tender offers are made, price is trading well below the tender offer, so any shares you have or buy can eventually be exchanged for a higher price. These deals are fairly low risk as the company doing the buying has usually made up its mind by the time the offer is announced, meaning the market will move quickly to price it as a near guarantee, but if you’re fast to act, you might be able to capitalize on the lower price before the spread vanishes.
Liquidations
Liquidations refer to when a company liquidates assets to pay out to shareholders. If the value measured by the share price is less than the value of the company after its liquidation payout, there is a chance to profit off an arbitrage trade by buying the stock and holding it until it reaches the expected value post-liquidation. Determining the liquidation payout, then, is all you really need to do. If the company is doing a complete liquidation, that number could be found through some simple balance sheet math, but if it’s a partial liquidation of their assets, it might require some deeper digging. In either case, you’ll just want to make sure you have the value of the liquidated assets right and add that to the current share value as best as you can. Some of the value may already be priced into the share price, so there isn’t always a perfect answer, but often times it is quite clear the current price and the value after liquidation don’t line up, meaning there is a spread to capture through arbitrage.
Spin-Offs
Spin-offs occur when companies or conglomerates spin off one or more companies under their umbrella company to shareholders. In other words, it’s when a parent company releases one of its subsidiaries as a separate stock to try and unlock its full value. This often happens when a company owns a lot of mediocre businesses and one or two good ones and simply wants to see how well those good ones do without being weighed down by everything else. Spin-offs are a good way to get a great company at a discounted price because its initial price is usually based on the fundamentals of the conglomerate rather than its own isolated business. This means you can buy the spin-off company at its discounted price and eventually sell it as it converges with its intrinsic value.
Unlike many of the other forms of arbitrage, this method requires a lot of skill in valuing companies. It’s possible intuition or common sense will tell you the spin-off is clearly worth more than its original listing price, but it’s much harder to know when the fair value is reached and it’s time to sell without doing a little math. Nevertheless, spin-offs create excellent arbitrage opportunities, especially if the initial price is severely hampered by the conglomerate’s other struggling businesses.
CONCLUSION
While there are plenty more types and examples of arbitrage I could get into, I think this is has been more than enough for an introduction, especially if you weren’t already familiar with all the different kinds of arbitrage out there. But given the ubiquity of arbitrage in financial markets and its relatively low risk compared to other types of trades, I think it’s an important concept to understand in all its many forms. Much like the ability to trade assets on the short side widely expands your opportunity in markets, adding arbitrage to your arsenal further expands the kinds of trades you can take. For many traders, that is their sole specialty, so try to consider all the potential arbitrage trades out there and how you might be able to capitalize on them because it’s a vast world with plenty of money to be made.