Arbitrage: a Smart Trading Strategy for Quick and Safe Profits
“Give a man a fish and you will feed him for a day. Teach a man to arbitrage and you will feed him forever”
– Warren Buffett
How Does an Arbitrage Work?
Trading is more interesting, more safe and more rewarding when you know what the price of a security will be at a particular date. That’s what arbitrage is about. Let’s take an example. A company wants to buy another one for $100 a share and wants to close the deal in 12 months. Before the announcement, shares of the target company were trading at $80. After the announcement, the price rise but stabilize at $94. The small discount to $100 represents the risk the deal doesn’t go through. There are at least $6 per share to earn if the deal completes and maximum $14 to lose if the deal doesn’t complete, as shares would likely drop back to their pre-announcement level. Several things can make the deal fall of such as stockholder disapproval or negative government action for example.
If the deal goes as expected, you get $6 dollars for any share you bought at $94, that is a 6.4% return in a year. If the deal completes earlier than expected then your annualized return rises. Your annualized return rises to 13% if the deal completes in six months and skyrockets to 28% if the deal completes in three months. If the deal is made at a higher price than expected then again your annualized return increases.
A Smart Trading Strategy
You know the maximum you can lose, the minimum you can earn and you can estimate the probability it works out well to select only the best opportunities. Amazing, isn’t it? These opportunities arise from corporate activity such as mergers, spin-offs, liquidation, etc. You can find many opportunities by reading the news. Most of the time, the gross profit appears to be small. The secret is that high predictability coupled with a short time-frame can produces great annualized returns. It ends up being far more interesting than speculating on rumors, taking higher risks in the hope to get high gross profit. A low but certain and quick return is much better than a hypothetically high return. And because these arbitrage opportunities depends on corporate action, they are not correlated to the general behavior of the market. You can find opportunities no matter what is the level of the market and you can get great returns even when the stock market is falling.