Arbitrage

One of the unique investment techniques I use for my clients is arbitrage. Arbitrage is a concept that has been around for decades, if not centuries. Most investors have heard the word but have no clue what it means.

The basic premise of the arbitrage theory is that investors can force a profit opportunity to exist. In its most simple form, it is about buying in a cheap market and immediately selling in a more expensive market. A good example would be the farmers’ markets found in two different villages. John goes to Cheap Village and sees that oranges are selling for $3 per bushel. He has heard that oranges sell for $3.50 in Expensive Village. John buys oranges at $3 per bushel in Cheap Village, then walks to Expensive Village and immediately sells them for $3.50. This is basic arbitrage—John has created a profit of $0.50 per bushel.

There are four keys to arbitrage, outlined as follows:

• Information: John had to know that the oranges were selling for $3 in Cheap Village and $3.50 in Expensive Village.
• Profit opportunity: John had to see a profit-making opportunity, which is the key motivation to arbitrage.
• Judgment: John had to use his judgement and determine the risk/reward factor.
• Decision: John had to make the decision whether to actually carry out his arbitrage transaction.

Theoretically, arbitrage should not exist, because market forces should eliminate it. Taking the simple example of the farmers’ markets and applying it to two financial markets, presumably no one would buy a security at a more expensive price than they could find in another market, and no one would sell a security at a cheaper price than is being quoting in another market. The prices in the two markets should converge — in theory. In real life, however, people make irrational decisions based on emotions quite often, especially in turbulent markets. You can profit from their behaviour.

We are ready to share with you the information and the profit opportunity that will reduce your overall risk. You apply your judgement and make a decision. Many of my clients include elements of arbitrage in their investment approach and have benefitted from it enormously over the years.