Arbitrage Trading – An Helpful Technique
Trading and investing are two risky activities. The field is so risky that on a daily basis millions of people lose money on a daily basis. Even the most successful traders and investors are alive to the fact that their trading involves risks. Many of them have lost tremendous amount of money in the past. Warren Buffet, one of the most successful investors of our time has lost money in the past. The same is true for William Ackman, the poster boy of activist investing who has managed to lose more than $8 billion in the past one year.
However, there are a number of strategies that successful hedge funds use to reduce the risks of losing money. Hedge funds derive their name from the fact that they hedge their trades. This means they make money regardless of the direction the market moves. In simple words, they are uncorrelated to the market movements. Arbitrage Trading in the simplest term is the act of buying an item (such as gold) while simultaneously selling a related item (such as the dollar) in the same market or in a different market. The idea behind this is that of correlation.
Correlation is a statistical process that measures the mutual relationship between items. In the financial market, the correlation can be between items in the same industry (such as Facebook and Twitter) or items that are in different areas such as crude oil and the dollar. It could also be between different markets such as the Nikkei and the Dow. The foundation of correlation is that items in different sectors are in some way related. For instance, though crude oil and dollar are different, the dollar is used to buy oil. This introduces some sort of relationship.
Arbitrage trading when used well can be very helpful to traders. Let’s take a good example of what has been happening in the crude oil market. This year, WTI (Western Texas Intermediary) and Brent (the global benchmark) has been moving in the same direction as shown in the chart below.
This means that WTI and Brent have the tendency of moving in the same direction. This can be explained in terms of demand and supply. When the supply of oil rises, the effect is that the price of oil will go down. When the supply eases, then the price moves up. Therefore, if there is a glut in the market, all the oil in the market will be affected. This effect will move to the oil drillers and also the oil marketers who will suffer from the reduced oil prices. This will also be transferred to the gasoline prices.
The same concept is similar in other items/assets. For instance, in the steel business, an increase in the amount of steel in the market has the impact of pushing the steel price down. With the steel price down, the effect of this is that the infrastructure industry will enjoy a period of reduced prices. Therefore, a steel company such as ArcelorMittal will likely have a negative correlation with a company such as Century 21 which is a real estate developer.
At face value, it seems that arbitrage trading is a simple idea. However, to be successful, you need to understand how to do correlation techniques. Luckily, there are many tools online that can help you carry out correlation of various assets. This is especially because the correlation of the assets changes from time to time. A correlation result of 1 indicates a perfect correlation while that of -1 shows inverse correlation. In case of a perfect correlation, such as in Brent and WTI (at the time of writing this), you can buy one and sell the other one in small quantities. This will help you mitigate the losses.