Risk Arbitrage Tools for Day Traders - dummies

Risk Arbitrage Tools for Day Traders

Because so few opportunities for true arbitrage exist, most day traders looking at arbitrage strategies actually practice risk arbitrage. Like true arbitrage, risk arbitrage attempts to generate profits from price discrepancies, but like the name implies, risk arbitrage involves taking some risk.

Yes, you buy one security and sell another in risk arbitrage, but it’s not always the same security and not always at the same time. For example, a day trader may buy the stock of an acquisition target and sell the stock of an acquirer in the hopes of making a profit as the deal nears the closing date.

Risk arbitrage usually involves strategies that unfold over time — possibly hours, but usually days or weeks. Pursuing these strategies puts you into the world of swing trading, which carries a little more risk than day trading.

Arbitrageurs use a mix of different assets and techniques to create these different ways of buying the same thing.

How day trader use derivatives

Derivatives are options, futures, and related financial contracts that draw or derive their value from the value of something else, such as the price of a stock index or the current cost of corn. Derivatives offer a lower-cost, lower-obligation method of getting exposure to certain price changes.

In the case of agricultural and energy commodities, derivatives are the only practical way for a day trader to own them. Because they are so closely tied to the value of the underlying security, derivatives form a useful “almost, but not quite” asset for traders looking for arbitrage situations. A trader may see a price discrepancy between the derivative and the underlying asset, thus noticing a profitable trading opportunity.

Using a derivative in tandem with its underlying security, traders can construct a range of risk arbitrage trades. For example, a trader looking to set up arbitrage on a merger could trade options on the stocks of the buying and selling companies rather than trading the stocks themselves. The more arbitrage opportunities there are, the greater the likelihood of making a low-risk profit.

Short selling for day traders

Short selling creates another set of alternatives for setting up an arbitrage trade — one that’s almost necessary to the process. Short selling allows a day trader to profit when a security’s price goes down.

The short seller borrows the security that she thinks will decline in price, sells it, and then buys it back in the market later so that she has the shares to repay the loan. Of course, that difference is her loss if the price goes up instead of down. The arbitrageur can use this to bet on assets that are likely to go down in price when another asset goes up.

Synthetic securities

A synthetic security is a combination of assets that have the same profit-and loss-profile as another asset or group of assets. For example, a stock is a combination of a short put option, which has value if the stock goes down in price, and a long call option, which has value if the stock goes up in price.

By thinking up ways to mimic the behavior of an asset through a synthetic security, a day trader can find more ways for an asset to be cheaper in one market than in another, leading to more potential arbitrage opportunities.

A typical arbitrage transaction involving a synthetic security, for example, involves shorting the real security and then buying a package of derivatives that match its risk and return. Many risk arbitrage techniques involve the creation of synthetic securities.