An arbitrage is a trade that produces near risk-free and near guaranteed profits.  In general, independent and retail traders are not successful as arbitrageurs.  We’ll get into the reasons why in a bit.  But it’s still important to understand how arbitrages work, because they’re a fundamental part of the structure of the market.  Each arbitrage defines an equation, for lack of a better word, of how the prices of various instruments should be related to each other and to interest rates.  Some of these relationships are trivial to understand, but others are far from obvious.

In a true arbitrage, the arbitrageur starts with nothing but their credit worthyness.  Any money required is borrowed, and at the end of the series of transactions a guaranteed profit falls out.  The easiest way to understand arbitrages is just to look at some examples and see how they work.  Once you get the idea, it’s not that hard.

• Spot vs. Futures Storage: this is typically done with commodities – metals, oil, and grains.
  1. Borrow money
  2. Use that money to buy the commodity in the spot market
  3. Sell a futures contract to deliver the commodity on a future date
  4. Wait
  5. Deliver against the contract and collect money
  6. Use that money to repay the loan
• Spot vs. Futures Inventory:
  1. Maintain a running inventory of a commodity
  2. Sell from that inventory in the spot market
  3. Lend the money from the sale
  4. Enter into a futures contract to buy the commodity in the front (soonest) month
  5. Recall the loan from 3
  6. Use the money to take delivery on the futures contract
• Market vs. Market: there is a potential to do this any time more than one market trades the same thing.
  1. Borrow money
  2. Use that money to buy whatever in market A
  3. Sell whatever in market B
  4. Do whatever it takes to move the security from market A to market B.  This is easy for some things (stocks) and requires making and taking delivery for others (eg. oil).  In some cases you might need to run an inventory.
  5. Pay off the loan
• Carry Trade:  this is a combination bond/forex trade that takes advantage of differing interest rates in different countries
  1. Borrow money in a country with cheap borrowing rates
  2. Enter into a spot FX transaction to convert that to the currency of another contry with investment grade bonds and higher yields.
  3. Buy bonds in the foreign country.
  4. Enter into a future/forward contract to convert back to your base currency at bond maturity.
  5. Wait for maturity, swap currencies, and pay off the loan from 1.
• Off-The-Run Bond Arbitrage:on the run treasuries are the most recently issued ones by the US government of a given maturity – for example the most recent 10 year notes.  Off the run treasuries are older series – so for example 10 year bonds that are now 9.75 year bonds a quarter later.  In general, off-the-run treasuries have higher yields (lower prices) than on-the-run.
  1. Sell short an on-the-run treasury bond
  2. Buy an off-the-run treasury bond of almost exactly the same duration
  3. Wait until both bonds are off-the-run, and the close the positions
• Synthetic Stock Arbitrage: This is done with stock options.  The basic idea is that being long a call option and short a put option, plus cash, is the same thing as having the stock.  If you’re not clear on why that is, read up on options.
  1. Buy a call option at a given strike price and expiration date
  2. Write a put option at that same strike and date
  3. Sell short the underlying stock.
  4. Lend the money from the sale in 3.
  5. Wait for option expiration.
  6. Recall your loaned money and when the options expire you will exchange the money for stock via one option leg or the other, which in turn will cancel out your short.
• Program Trading (Index Future vs. Individual Stocks): Index futures are cash-settled futures where the amount of cash moves from one party to the other as the value of some stock index changes.  They can be traded against the underlying stocks as follows:
  1. Buy index futures in the S&P 500 index
  2. Sell short the 500 component stocks of the S&P in the ratio of their market caps
  3. Lend the money from 2
  4. Wait for the future to expire and re-call your loan
  5. Buy to cover the stock positions

There are numerous other examples, but these are some of the most common and you should be starting to see a general pattern.  Now we can discuss why arbitrage is hard for the little guy.  The profitability of each arbitrage is dependent on three things:

1. how far various prices are out of whack
2. the rates at which you can borrow and lend money
3. the cost of transactions, storage and transportation

What this means is that the best arbitrageurs will be those that can borrow cheaply, lend dearly, and minimize their transaction costs.  The better you are at those aspects, the smaller the price discrepancy needs to be for you to make money.  In other words, big institutions are going to be notably better at arbitrage than the little guy.  This is one place where a retail trader should pretty much give up on playing.  But it’s still worth understanding how they work, because they explain the pricing relationships between all sorts of instruments.  We’re going to revisit the program trading arbitrage in more detail in the speculative alternatives to investment series, because it turns out to help us out in a weird sort of way.  Stay tuned 🙂