Anton Schutz
Anton Schutz is founder and senior portfolio manager of Mendon Capital Advisors, Key Largo, Florida, which manages $1 billion. RMBFunds.com
If you spend time reading about finance topics, you’ve probably have come across the term arbitrage and perhaps wondered what it means…especially since the term appears to refer to different things in different contexts.
So what does arbitrage mean…and is there a place for it in personal investing? Portfolio manager Anton Schutz explains it all here…
The word “arbitrage” comes from the French verb “arbiter,” which means “to give judgment” in the sense of carefully weighing one’s options based on the observed facts.
In finance, “arbitrage” refers not to a single technique but rather to a principle of investing—specifically, taking advantage of the price discrepancies in different types of markets.
One example: Imagine that you were investigating the price of stock in a company called XYZ. On Stock Exchange A, you see that the stock is selling for $1.50…but on Stock Exchange B, the price is $2. Moving quickly, you purchase 10,000 shares of XYZ on Stock Exchange A and immediately sell them on Stock Exchange B, netting 50 cents per share for a total win of $5,000.
This is not a realistic example, but it does illustrate the basic principle of arbitrage—exploiting price differences in different markets or settings to make a profit.
There are many ways to apply the principle of arbitrage, some highly complex and suitable only for experts…others more basic and accessible to personal investors.
Some highly sophisticated investment firms have teams of experts who use complex computer algorithms to scan the markets for tiny pricing discrepancies in assets such as stocks, bonds, derivatives, commodities and currencies. Today’s markets are highly efficient, meaning that our grossly oversimplified example about XYZ stock above would never happen in the real world. Instead, the algorithms find and exploit fleeting pricing anomalies that yield fractions of a penny. To make any significant profit, investors must borrow inordinate amounts of money, known as leverage. This risky activity has been the downfall of some major firms.
This arbitrage technique also is mainly for professionals, but highly knowledgeable personal investors can use it, too. When two companies announce that one will be purchasing the other, investors can speculate on whether the deal will actually go through. If they’re betting the deal will be successful, they purchase stock in the target company at a discount. Once the acquisition is completed and the stock rises to the price agreed upon in the deal, the arbitrageur can sell the stock at a profit.
Some companies offer both convertible bonds (which can be converted to stock by the bondholder) as well as stock. In situations where the convertible bond is priced differently than the stock, a sophisticated investor may go long (a traditional position, in which an investor buys in hopes of selling at a higher price at a later date) on either the stock or the bond while short-selling the other. A short sale is when an investor believes the security’s value will fall, so he/she sells it first with the promise to buy it back at a later date—hopefully at a lower price, which allows him to pocket the difference. This arbitrage strategy allows the investor to collect yield on the convertible bond, while hedging his long position with his short position.
In this technique, sometimes called Airbnb arbitrage, an investor takes out a long-term lease on a vacation rental property and then offers it on the short-term-rental website Airbnb or a similar site. Example: Imagine signing a one-year lease on a house at $3,000 per month. If you can turn around and rent it out on Airbnb for $250 per night, then theoretically you’d bring in $7,500 per month. Of course, that’s assuming you can fill it with renters every single night, and it’s not counting the costs of keeping up the rental. But if the numbers come out right, then the difference in price based on rental duration (monthly versus nightly) could mean a tidy profit. Such arrangements are legal as long as they’re above-board and transparent to the property owner and the long-term lease holder.
Imagine you live around the corner from a discount store that is offering a cool t-shirt for $1. You buy up all 50 t-shirts the retailer has in stock and sell them on Amazon for $10 each. If you unload all 50 shirts, that’s a gross of $500. Not counting the costs of shipping and other labor, you turned your $50 investment into $450. Such maneuvers are sometimes called Amazon arbitrage, although the technique is not limited to that platform. Retail arbitrage opportunities are almost endless because they simply entail buying something cheap in one market and selling it at a profit in another.
Caution: When assessing a potential arbitrage opportunity, always take into account the risk that you will not be able to sell all of the asset, as well as the costs associated with getting it sold, such as marketing, storage, renting virtual or physical retail space, shipping, bookkeeping and so on.
