Take Advantage of Stock Price Discrepancies while Day Trading - dummies

Take Advantage of Stock Price Discrepancies while Day Trading

Financial markets are not perfect and day traders can make a profit by recognizing small discrepancies in the prices of stock or other securities. This trading strategy is called arbitrage. The idea is that the arbitrageur, or arb (the person who does arbitrage), arbitrates among the prices in the market to reach one final level.

In theory, arbitrage is riskless. It’s illogical for the same asset to trade at different prices, so eventually the two prices must converge into one price. The person who buys at the lower price and sells at the higher one makes money with no risk.

So how can you as a day trader take advantage of what you know about the one-price rule? Suppose that what you see in New York is not what you see in London, or that you notice that futures prices are not tracking movements in the underlying asset. How about if you see that the stock of every company in an industry has reacted to a news event except one?

Well, then, you have an opportunity to make money, but you’d better act fast because other people will probably see the discrepancy, too. What you do is simple: You sell as much of the high-priced asset in the high-priced market as you can, borrowing shares if you need to, and then you immediately turn around and buy the low-priced asset in the low-priced market.

Think of the markets as a scale, and you, the arbitrageur, must bring fairness to them. When the markets are out of balance, you take from the high-priced market (the heavier side of the scale) and return it to the low-priced market (the lighter side) until both even out at a price in between.

If you start with a high price of $8 and a low price of $6 and then buy at $6 and sell at $8, your maximum profit is $2 — with no risk. Until the point where the two assets balance at $7, you can make a profit on the difference between them.

Of course, most price differences are on the order of pennies, not dollars, but if you can find enough of these little pricing errors and trade them in size, you can make good money.