ARBITRAGE TRADING

APPARENTLY THE HOLY GRAIL?

It was represented in here the other day by someone that Arbitrage Trading is the holy grail of trading, is it?

Arbitrage trading is basically looking for very small price differences in securities that should not be different and are therefore temporary. Once you identify those, you put on a position to benefit from it coming back into line. Generally since these moves are miniscule, you have to trade huge volume on these types of trades to make a small amount of money. The argument is of course that the accuracy of the trades will be very high. What you wind up doing is a ton of large sized trades to make a few grand here and there. Annual returns due to how small the wins are, generally are in the 8 to 12% range for those who do this well.

As with everything, some do it better than others. I have a chart of the Premium above, which is the difference between the cash and futures prices of the SP 500. It is a daily chart, but can still serve as an example of how someone might go about trading using this concept. You can see that the values are contained in a range, this is typical. What you would do using this concept here would be to buy stocks and sell futures when the premium gets too high, and do the reverse when it gets too low. These are how buy and sell programs are triggerred on Wall Street. This is why you can see quick snap backs when large moves happen. They are known to happen at certain times during the day. This is also how you can tell when the PPT is at work. When these programs show up without any real discrepancy in this value, it is very likely a government sponsored move.

This is somewhat of a variation of true arbitrage and really just using the concept. Strictly speaking true aribitrage would be finding the exact same security that is traded in more than one place, trading at different prices. You would then buy it in one place and sell it in another to take advantage of it coming back to par.

The biggest negative with doing this type of thing is the amount of money required to make any real money doing this. In reality you need hundreds of thousands of dollars or more in margin money to be able to do trades like this. Also if for some reason you get an infamous "electronic death spike" you can get wiped out in one trade. I have always believed that to be consistently successful your avg win has to exceed your average loss. That will not be the case with this style of trading. Your average loss will be bigger and you make money by high frequency and high accuracy. A large loss will at times wipeout profits from many trades, I think that is very dangerous.

The second negative with this is that it is very high intensity, you need to be glued to the screen every second of the day looking for these minor edges to show up. You then have to act in a split second. You are competing against the smartest people in the world when you do this. They have very sophisticated models that are completely automated, that launch their orders the minute these little discrepancies develop. As time goes on it is more and more difficult to trade profitably doing this.

The benefit is that if you do this properly you should be able to eek out very small profits consistently and make slightly above average returns. If you are highly intelligent and very skilled in writing programs to take advantage of this, it is a viable way to trade. However, do not look for any home runs, there will not be any. You are in and out in seconds doing these types of things.

I am fairly sure that the two day span I had last month made a greater percentage return in my accounts than the lion share of arbitrage guys will make this year. However, if they are trading $100 million dollars and make 10% on it, that is alot of jack. You need deep pockets to do this and just be aware of the pluses and minuses of it before getting into it.