Pure arbitrage ( Thanks to Matt Teeter, CFO)
Pure arbitrage involves purchasing some underlying stock and simultaneously selling it for a higher price. If these two transactions can be completed at the exact same time, there is no risk taken. This is normally done between two exchanges that have different prices for the same security. Due to the straightforward nature of this strategy, it is very crowded and these opportunities do not exist for long. Cryptocurrencies have more of these opportunities than any other asset class and it is possible to make 5%+ returns if a trader is careful and crafty about the way they make the trades.
The more advanced way to perform pure arbitrage is through the use of derivative contracts. For example, let’s say the S&P 500 is currently trading at $2,500 on November 1st. The S&P 500 Mini Futures contract is trading at $2,700 and expires on December 15th. A trader has the opportunity to buy the S&P 500 while simultaneously selling the futures contracts to lock in a gain of 8% over a month and a half. Since the futures contract is based on the underlying S&P 500 stocks, there is no risk.
Statistical Arbitrage ( Thanks to Matt Teeter, CFO)
Statistical arbitrage, commonly referred to as stat arb, is a more complex version of arbitrage than pure arb. It involves buying and selling two different securities that are in the same industry to take advantage of pricing inefficiencies. This is typically done by watching the correlation between two stocks and trading them when the correlation diverges from the long-term average.
Let’s look at an example of this between two popular stocks, Coca-Cola (KO) and Pepsi (PEP). The long-term average correlation between KO and PEP stock is .7, meaning that they generally move in unison. Imagine that all of sudden, PEP has a supplier that goes bankrupt and makes national news. Over the next month, PEP drops 10% in anticipation of the bankruptcy’s effect on their supply chain. KO remains unchanged over the month. The correlation between the two stocks now drops to .4, since PEP dramatically underperformed KO. A smart stat arb trader could use this opportunity to take a long position in PEP and a short position in KO. As soon as the correlation returns to its historical average, the trader will be able to take off both positions and profit from the return to the mean.
*image courtesy of NASDAQ
There are many benefits to this form of trading. The primary benefit is that the trader remains market neutral. This means that they have neutralized their market risk due to the fact that they are both long and short stock. This also allows the trader to ignore specific price movements on one stock versus the other and focus solely on the spread between them. Traders do not have to predict anything about the underlying stock or the market in which it trades, only whether or not the correlation has been thrown out of balance and will revert. This doesn’t just have to be done on stocks, it can be done on a variety of different markets including commodities, Forex, and cryptocurrencies.