Arbitrage is one of the main strategy groups employed by hedge fund managers to achieve their stated goal of returns in any market, and relative-value arbitrage is one of the most common sub-types of this strategy. Today, we are going to give an outline of how this strategy works, and how it is used by money managers in order to make profits from trading financial instruments.
Arbitrage and Short Selling
In order to understand how it works, we need to know a little about the concept of arbitrage and how it can be used to make profitable trades. In simple terms, arbitrage is an investment strategy that aims to extract profits from the price differentials or ‘inefficiencies’ between complementary financial instruments. This is achieved by purchasing or ‘going long’ on one security while simultaneously selling or ‘going short’ on the other. If successful, this allows the investor to profit from the differences in price between these two securities. It is a strategy that can be employed across a wide range of financial instruments, including stocks and bonds, derivatives such as futures contracts or options, and commodities.
The simplest form of arbitrage this entails buying securities on one market to sell on immediately in another at a profit, taking advantage of the pricing discrepancies between these two markets. However, in the context of hedge funds, an arbitrage trade or ‘arb’ usually entails the simultaneous buying and selling of two securities that have a strong correlation in terms of pricing that are currently further apart or closer together than the trader believes they should be.
In this context, an arbitrage trade is made on the assumption that the prices will revert to what the trader believes to be their true value. Therefore, the trader goes short on the security they believe to be overpriced security and goes long on the security they believe to be underpriced. Then, if and when the prices revert to their true value, the trader can profitably liquidate the trade.
By ‘going short’, we mean borrowing a security, selling it, then hoping that its value falls. If this transpires, you can then buy it back at a lower price and return it to the lender and pocket the difference in prices between what you sold it for and what you bought it back for, minus transaction fees of course.
Relative Value Arbitrage
Relative-value arbitrage is more commonly referred to by traders as pairs trading. The reason for this is that, with relative-value arbitrage, an investor will make simultaneous investments in a pair of securities that are related in some way. For the most part, these securites will have high positive correlations (in that they tend to move in the same direction at the same time) or high negative correlations (in that they tend to move in opposite directions to each other).
One common approach to pairs trading is to trade two stocks in the same industry that have been on the market for a similar length of time, such as Pfizer and Wyeth in the pharmaceutical industry or Ford and GM in the auto industry. However, there are lots of other financial instruments that can be employed to similar effect. For example, you can use entire stock indices such as the Dow Jones Utilities Average and the S&P 500 Index for relative-value arbitrage trades, or index-tracking stocks such as the SPY (which tracks the S&P 500 Index) and the QQQQ (which tracks the NASDAQ Composite Index). In addition, you can also employ this strategy with currencies, commodities, futures, and options.
Regardless of the securities being used, when there is a divergence in the price – for example if one security rises in price and the other falls, the arbitrage trader would buy one of the securities and short the other one. Then, the trader would close the trade if and when the prices converge again, thereby locking in a profit.
Because of the need for a strong price correlation between the two securities, this strategy tends to be most effective in a range-bound market that is neither rising nor falling. However, because markets can change direction quickly, it can be tricky to tell whether a range-bound market will stay that way or start trending in one direction or the other. Therefore, in order to profit from this strategy, you need to have the knowledge and skill to evaluate the markets themselves as well as individual securities, and this is why this is a strategy that is almost exclusively used by large institutional investors such as investment banks, hedge funds, and private equity firms.
The main appeal of relative value arbitrage strategies is that they can be used to extract profits in markets where it is difficult to do so otherwise, such as range-bound or ‘sideways’ markets. However, the skill level required to succeed with this strategy means that it is only really a strategy that is suitable for high-end investors who are willing to – and understand – the risks involved.