Types of Arbitrage
In this segment, we look at the arbitrage types and the different types of arbitrage. Arbitrage trading is not just about cash-futures or exchange to exchange trading. Arbitrage is a complex subject. There are different types of arbitrage trading including the use of options and macros. Here we look at the types of arbitrage trading in detail and how to make the best of these. Here is a quick take on the types of arbitrage trading.
Types of Arbitrage
When we discuss the different types of arbitrage strategies, we focus on two broad categories. The first category is the macro arbitrage strategies. The second category is the more complex option-related arbitrage strategies. Let us delve in detail into types of arbitrage strategies.
Types of Macro Arbitrage strategies
Macro arbitrage is quite popular among arbitrage traders, especially higher-risk players like hedge funds. Here are is a look at types of macro arbitrage strategies.
- Risk arbitrage or Merger Arbitrage is one of the common trades in capital markets. This strategy entails buying stocks that are in the process of a merger or acquisition or amalgamation. Merger arbitrage is popular among hedge funds with a higher risk appetite. They buy the target company’s stocks and short-sell stocks of the acquirer. Such strategies are normally leveraged using futures.
- Retail arbitrage is more of a business-level arbitrage that is done in retail products and products of mass consumption. For example, platforms like Alibaba and Amazon have a plethora of low-cost products that are sourced in China and sold online at a much higher price in different markets where it still makes economic sense.
- Convertible arbitrage is another extremely popular arbitrage strategy. The convertible arbitrage involves buying convertible security like partially convertible debentures or a full convertible debenture and short-selling the underlying stock when there is mispricing visible.
- One of the most popular forms of arbitrage in the modern world is what is popularly referred to as statistical arbitrage. This is an arbitrage technique that entails complex statistical models to decipher trading opportunities across different market prices. Those models are popularly called mean reversion strategies where you bet on prices and trends coming back to normal after significant deviations.
The exotic world of options arbitrage
Broadly, there are four types of options arbitrage popularly used in the market. Here is a quick rundown on each of them.
- The first type of options arbitrage is known as Put-Call Parity Arbitrage. For example, if you apply the basic Black & Scholes model, the call and put off a particular strike have to hover around a certain intrinsic value. If either the call or put is way off the intrinsic value, it gives rise to put-call parity arbitrage. For example, a call option may be under-priced about a put based on the same underlying security. Alternatively, the call option could also be overpriced compared to another call with a different strike or a different expiration. Whenever the put-call parity is significantly disrupted, it gives rise to arbitrage.
- The second type of options arbitrage is called Strike Arbitrage. The strike arbitrage occurs when there is a price discrepancy between two options contracts that are based on the same underlying security and have the same expiration date but have different strikes. For example, if the premium of the Reliance 2200 call is inordinately higher than the premium on the Reliance 2140 call. That is a case of strike arbitrage.
- The third form of options arbitrage is Reversal Arbitrage. First a quick word on synthetic options. Synthetic options allow the use of a combination of options and stocks to precisely recreate the characteristics of another position. Here., the arbitrage opportunity arises if the synthetic positions have substantially diverged from the price of the reflective asset. Since synthetic positions emulate other positions in terms of cost and payoff characteristics, the Reversal arbitrage is a bet on mean reversion.
- The Box Spread is a lot more complicated and involves multiple legs to the transactions and a virtual repeat at closure. The box spread is also called the alligator spread since normally the commissions and costs eat away the box spread profits, which is why it is not too practically viable. A box spread is a combination of a conversion strategy and a reversal strategy. To give an analogy for box spread, instead of going long and short a stock, you combine a bull call spread and a bear put spread.
All you Need to Know About Arbitrage
Arbitrage is about mispricing and the arbitrageur exploits such mispricing by buying in the under-priced market and selling in the overpriced market to earn riskless profits on the arbitrage transaction.
Cash and Carry Vs Reverse Cash and Carry
In a cash and carry arbitrage transaction, the trader buys the spot position and sells the futures position. The necessary condition is that the futures are more than the expected spot price. In other words, the futures price is more than the spot price plus the cost of carrying. In the case of reverse cash and carry, it is normally done when the futures are at a substantial discount to the spot. In such cases, you sell existing delivery and buy the futures when futures are at a discount with the idea of reversing and making a risk-less profit on expiry.
Frequently Asked Questions Expand All
Reverse cash-and-carry arbitrage is a market-neutral strategy combining a short position in an asset and a long futures position in that same asset. You can look at this strategy as the exact opposite of the traditional cash and carry arbitrage. The goal of this reverse cash and carry arbitrage is to exploit pricing inefficiencies between that asset's cash, or spot, price and the corresponding future's price to generate riskless profits. Normally, the reverse cash and carry arbitrage is done by traders who are owning the shares in their portfolio and when the cash-futures spread becomes negative, you indulge in reverse arbitrage. These are not common and arise infrequently.
You can just understand the reverse cash and carry as the opposite of a normal cash and carry arbitrage. The reverse cash and carry is done only when the futures is at a discount due to mispricing.