What are Different Arbitrage Strategies Used?

Arbitrage strategies are risk-free strategies to capitalize on price discrepancies. Here we look at different types of arbitrage trading strategies and the types of arbitrage strategies. While trading arbitrage strategies, it must be remembered that arbitrage has certain basic conditions like no-one price rule that must be adhered to. Here we look in detail at the various types of arbitrage strategies in domestic and international markets.

Different Types of Arbitrage Strategies

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 concerning 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 substantially diverge 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.

Risk-Free Arbitrage Trading

The act of buying an asset and immediately selling the same asset for a higher price in a different form that is interchangeable is called risk-less or risk-free arbitrage. The short time frame involved means that riskless arbitrage occurs with a very short lock-in period. The returns are locked in at the time of initiating risk-free arbitrage itself like in cash futures.

Advantages of Arbitrage Trading

There are some key advantages in arbitrage trading that one can encapsulate here. Let us identify and enumerate 3 such advantages.

  • The biggest benefit of doing arbitrage is that the risk element is zero, or to be more precise the risk element is almost zero. That is because in arbitrage you are looking at an interchangeable asset like spot and futures or spot basket and index futures or same index in different markets.

  • Arbitrage helps in keeping the price of stocks and assets across various markets more or less the same and thus makes markets more efficient. Eventually, this helps in better price discovery and avoids price variances across different markets.

  • Arbitrage contributes more to the efficiency of any market than most other factors. If there were no arbitrageurs then stocks would keep trading at different prices in different markets leading to speculation by a handful of traders having access to data and information. That would be unfair to small investors.

Frequently Asked Questions Expand All

Arbitrage is technically possible when one out of the three conditions are met.

  • The first condition of arbitrage is the Law of No One Price. It must be ensured that the same asset does not trade at the same price on all markets. In other words, two assets with similar or identical cash flows must not trade at the same price.

  • An asset with a known futures price must not trade today at its future price discounted by the risk-free interest rate. That would be perfect pricing and would obviate any arbitrage opportunities.

  • Arbitrage can only happen if both transactions can simultaneously occur to avoid exposure to market risk, or the risk that prices may change in the interim. Hence, this arbitrage is only possible where assets can be traded electronically and seamlessly.

Broadly, there are 3 kinds of international arbitrage opportunities that are available in the global markets today.

  1. Covered Interest Arbitrage takes advantage of interest rate differential between two countries by hedging under forward contracts to earn riskless profit. This is also called carry trade in popular parlance where you borrow in a country with lower rates and deploy in another country with higher interest rates; neutralizing currency risk.

  2. The second form of international Arbitrage is called Two Point Arbitrage. Buying a currency in one market and selling it at higher price in another geographically different market is called two-point arbitrage. How does this arbitrage arise. Normally, the rule is that the exchange rate for a said currency should be same in every part of the world. However, due market or trade or flow level discrepancies, prices might be differ in various markets. In such cases, the arbitrageur buys the currency in the market where its price is lower and sells the currency in the market where its price is higher.

  3. The third type of international arbitrage is the Triangular or Three-point arbitrage. Triangular Arbitrage is normally the result of mismatch of exchange rate of three currencies, which is why it is also called cross-currency arbitrage. Here, the arbitrageur takes advantage of discrepancy among three different currencies in the foreign exchange market.