Are you familiar with the term arbitrage? It is simply the process by which you make money by taking advantage of pricing differences. And there are many ways you can use arbitrage to your advantage, including the stock market.
Today we are going to look at arbitrage in detail and show you 2 simple ways you can profit from price differences in the stock market.
Before we talk about how you can make money in the stock market by using arbitrage, let’s first look at a few examples to ensure you understand this concept.
A great example is with selling online and yard sales. Many people find deals at yard sales and then flip, or resell the item they just bought for a greater value. This could be done because the seller doesn’t understand the true value of the item, or because there isn’t a strong local market for the item.
For example, let’s say a person in Florida is selling a winter coat. They ask $5 for the coat. Obviously there isn’t great demand for a winter coat in Florida, so there are few buyers. But a snowbird from Maine buys the coat and when they go home, they sell it on Craigslist for $15.
This is arbitrage.
When it comes to the stock market, you can take advantage of arbitrage too. However until recently it has been difficult to do so. This is because to truly find a security that you could quickly flip due to price differences was close to impossible.
The market moves so fast, that the only ones who really can take advantage of it are the large brokerage houses and their powerful trading computers.
But nowadays, there are funds you can invest in that turn the power of arbitrage in your favor. Additionally, there is a strategy you can use to quickly profit from price differences as well. Let’s take a look at these options.
2 Ways To Make Money Using Arbitrage
#1. Mergers And Acquisitions
Nearly every day, or so it seems, there are companies agreeing to buyouts and mergers. Usually this process involves an announcement and the company who is being taken over sees their stock price catapult.
This is because the company buying them is doing so for a higher share price than the stock is currently trading at. How can you take advantage of this spike in stock price?
You can buy a mergers and acquisitions exchange traded fund. There are two out there whose sole mission is to take advantage of the profit spread.
In both these cases, these ETFs don’t provide solid long term returns, most likely because not all mergers see the stock prices surge for the takeover target. Still, this is a simple way to get into the market for arbitrage.
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#2. Pair Trading
Another option to consider when looking at arbitrage is pair trading. This is when you take two securities that are closely aligned and take advantage of their pricing difference.
For example, let’s look at ETFs that track the S&P 500 Index. This is an easy one to start with, simply because there are so many funds that do this.
Your goal is to look for two funds that are trading at different prices. To profit, you buy the exchange traded fund that is underpriced and sell the exchange traded fund that is overpriced.
As the buying opportunity closes, you will see the value of the underpriced ETF rise in value, earning you a positive return on your money.
However, as I mentioned earlier, this is tough to do. These opportunities only show up for a short period of time, so you need to act quickly.
Taking advantage of arbitrage in the stock market is possible but difficult. As a result, most investors are better served taking a long term investing approach. Going this route will result in greater returns and most likely a lot less volatility.
But if you are set on trying to profit from arbitrage, the ideas I presented above are good starting points for you to research in more detail.