When there are so many alternative investment options, there are various strategies as well as tricks that you could use. These strategies could often be different from the standard “buy and hold” method that a majority of long-term stock and bond investors use—in fact, these could be more complex. Visit multibank group
Arbitrage is an example of such an alternative investment strategy which could turn out to be very profitable when it is leveraged in the right manner by a smart investor. It also includes certain risks that one should take into account. To be able to have arbitrage in your alternative investment strategy in an effective manner, it’s necessary to comprehend the nuances as well as the risks. Here’s an overview of arbitrage and the types that one should be familiar with:
What is arbitrage?
Arbitrage refers to an investment strategy where an investor would buy and sell an asset in various markets at the same time. They do so to make the most of the price difference in these markets to earn a profit. Even though price differences are generally not too big and have a short life, they could bring good returns if they’re multiplied by a large volume. Arbitrage is typically used by hedge funds and other such complex investors.
There are many types of arbitrage, such as pure arbitrage, merger arbitrage, and convertible arbitrage. Global macro is yet another investment strategy associated with arbitrage. However, it is seen as a fresh approach as it points out to investments made in economic changes between different countries.
Types of arbitrage
Macro Arbitrage strategies
Macro arbitrage enjoys a lot of popularity among arbitrage traders, particularly higher-risk players such as hedge funds. Here are some of the top macro arbitrage strategies.
- Pure Arbitrage
Pure arbitrage is the investment strategy where an investor buys and sells the same security in different markets to earn from the price difference.
Every time an asset gets traded in different markets, it’s likely that the prices go out of sync temporarily. Pure arbitrage can take place only because of the price difference.
Pure arbitrage could also happen in case there are discrepancies in Forex prices.
At the end of the day, pure arbitrage refers to a strategy where an investor makes the most of market inefficiencies.
- Merger Arbitrage
Merger arbitrage refers to arbitrage related to merging entities, like two businesses that are publicly traded.
In general, there are two parties in a merger. One that acquires the company and another that is the target. Should the target company be a publicly traded entity, the acquiring company would have to buy the outstanding share of the company in question. In a majority of cases, it comes at a premium to what the stock trades when the announcement is made which ensures that the shareholders earn profit.
Once the deal is made public, traders seeking profit from the deal would buy the target company’s stock which further steers it to the announced deal price.
To put it simply, merger arbitrage includes an investor who buys the target company’s shares at a discounted rate and earns a profit as the deal is processed. However, there are several forms of merger arbitrage. An investor may think that a deal would not be successful and could also short shares of the target company’s stock.
- Convertible Arbitrage
Convertible arbitrage refers to a form of arbitrage associated with convertible bonds, such as convertible notes or convertible debt.
A convertible bond in essence is just like another financial bond such as a corporate debt which brings interest payments to the bondholder. The key difference between a convertible bond as well as a traditional bond is that the bondholder would be able to convert a convertible bond into shares of the underlying company at some point in the future at a lower rate. Companies roll out convertible bonds to be able to offer lower interest payments.
Investors who work with a convertible arbitrage would want to make the most of the difference between the bond’s conversion price as well as the present price of the underlying company’s shares. This is generally done by opening long and short positions simultaneously in the convertible note and underlying shares of the company.
The investor’s positions and the proportion of their buys and sells would rely on the investor’s take on the bond’s pricing. Should the bond be seen as cost-effective, they would typically take a short position on the stock and a long position on the bond. Whereas should the investor think that the bond is pricey, they may choose to take a long position on the stock and a short position on the bond.
The exotic world of options arbitrage
On the whole, you will come across four types of options arbitrage:
1.Put-Call Parity Arbitrage
The call and put off a particular strike tend to focus on a particular intrinsic value. In case either the call or put moves away from the intrinsic value, it leads to put-call parity arbitrage. For instance, a call option could be underpriced because of a put based on the same underlying security.
2.Strike Arbitrage
The strike arbitrage happens when there is a difference in the price of two options contracts which are on the basis of the same underlying security and also come with the same expiry date but with different strikes.
3.Reversal Arbitrage
Synthetic options enable using a combination of different options as well as stocks to quickly copy the characteristics of another position. In such a case, an arbitrage opportunity arises when the synthetic positions remarkably move away from the price of the reflective asset. Know more herramientas de comercio de divisas
4.The Box Spread
The box spread could be much more complex and has several transaction legs along with a virtual repeat at closure. The box spread is referred to as the alligator spread because generally commissions and costs take over all the box spread profits, making it completely impractical. It is a mix of a conversion strategy and a reversal strategy. It would be similar to opting for going long and short a stock only to mix a bull call spread and have a bear put spread.
