Investing

Understanding Stock Arbitrage

Meaningful Return With More Safety

Investments are the primary method of saving for retirement. If you don’t know what you’re doing, you are at a disadvantage. On the other hand, if you know the market better than other people, you can find yourself with a considerable advantage. Diligent research and understanding of the principles at play in business deals can put you in a position to find arbitrage possibilities providing strong returns with less risk.

Arbitrage is an essential principle in investing. Knowing where to look for undervalued opportunities puts you in a position where you can be more confident in growth potential. Where many have their money managed by other people and hope for the best, understanding arbitrage will provide you with the chance to control your cash confidently.

In this article, you will receive a stronger understanding of how arbitrage works, where you can find it, and how you can implement the strategy in your own life. A comprehensive review of stock arbitrage is something requiring book-length. For those interested, it is recommended you research more into the execution of stock arbitrage from those who have done it best.

Levels of Arbitrage

With any form of investment, levels of risk tend to reflect opportunities for profit. The more uncertainty that is involved, the higher the reward you stand to gain. While this can also be true for arbitrage, a person seeking pure arbitrage should be looking for lower risk with more certain gains from undervalued assets.

For example, a classic form of arbitrage is taking advantage of the acquisition of a company by a larger company. With the way the media reports on events in the economy, no significant acquisition is happening by surprise these days. Stories will speculate future deals the moment possibilities begin to develop. These initial reports won’t have as much sway on the price of shares when they are still only speculation. You may see movement when deals look more defined. The complications behind significant acquisitions mean deals could fall apart at any juncture of the process. So, taking the bait of speculation may end up being a waste of your time.

Some of the most successful investors of stock arbitrage will only make a move after a public announcement of an acquisition. At that point, there will be much less profit available, but that profit is as close to a sure thing as you can get with stock purchasing. 

Arbitrage Opportunities

Arbitrage opportunities come in many different forms. Each of these opportunities has its own set of details to pay attention to for successful arbitrage execution. 

Friendly Merger

When two companies agree to merge in what is considered a mutually beneficial situation, one of the two companies will still take on a more dominant position. In this scenario, the arbitrage opportunity is with the securities of the less dominant company. 

Identifying the dominant company is simple. Whichever company offering its cash or shares for the shares of the other company is the dominant one. More complicated is the terms of the deal. With these mergers, you could see a stock-for-stock exchange, a cash-for-stock agreement, or a deal exchanging both cash and stock.

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The easiest of these deals is when cash is used by the dominant company to absorb the other company. In this situation, if the price offered per share is higher than the current value of the stock, there is an arbitrage opportunity. Cash will be paid out for each share owned in the agreed amount. Your profit would be the difference between the price at which you acquired your shares and the price paid per share by the dominant company. 

When the exchange of stock is involved, you may need to short the shares that you acquire to protect your profits from fluctuating markets before the deal is final. Calculating this arbitrage depends upon knowing how many shares the dominant company will offer for each share of the absorbed company. If the total value of the offered shares is higher than the cost of a single share of the absorbed company, there is an arbitrage opportunity. 

Takeover

In a merger, one company agrees to be acquired by the dominant company. In a takeover, one company wants to buy another company that does not want to sell. The company attempting the takeover can move forward by trying to gain a controlling interest in the company it wishes to acquire. To do this, it will bring its offer straight to the shareholders of the company. This kind of acquisition is much less frequent than a friendly merger.

This kind of deal comes with much more uncertainty and many variables. The scenario that leads to the most substantial arbitrage opportunity is when a bidding war takes place, driving up the amount of money paid per share. This kind of bidding war gives these arbitrage opportunities the chance to be more lucrative.

Liquidations

When a company is worth more through its deconstruction than its operation, an arbitrage opportunity exists. Being aware of that opportunity and having events fall into place is another matter entirely. 

Often, this kind of arbitrage opportunity takes place with the liquidation of Real Estate Investment Trusts (REITs). Many of these trusts are in smaller areas that do not have large scale media coverage of national outlets. Thus, the correction of share price after a liquidation announcement will take time and provide you an opportunity to get in on the arbitrage.

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The opportunity in this arbitrage depends on the liquidation value being higher than the share value and shareholders approving the liquidation (if the liquidation value is higher than share prices reflect, this will likely happen). Knowing how long it will take to sell assets is also essential. If the complete liquidation of the properties will take years, this will eat away at your rate of return. An extension in the sale of assets does not necessarily mean the arbitrage will lose its value, but you should make sure your return is worth the wait.

More Opportunities

There are plenty more opportunities for arbitrage in the market. Mentioned above are a few of the best for a beginning arbitrageur to work on identifying. Sharpen your skills before jumping into the market. Some of the other opportunities include buybacks, spin-offs, and stubs.

Some of the most successful investors have made vast amounts of money through stock arbitrage. Success in the world of arbitrage requires keen attention to what is happening in the markets. It would help if you also stayed informed on laws changing your taxation in these transactions. Understanding the nature of arbitrage and quality execution can yield handsome rewards.

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