Now that I have described pair trading, the next topic of interest lies in “risk free” arbitrage strategies. Due to the generally limited literature, this topic remains largely hidden behind institutional trading.

Definition of classical arbitration

Classic arbitrage applies to any trading strategy in which one exploits market inefficiencies for a self-funded, risk-free profit. Discrepancies in the offered values ​​of the same underlying products/services present the aforementioned “market inefficiencies”.

I had provided some examples a while back on the blog. They present some straightforward and practical business models or business schemes applied by real life people.

Are they really completely risk free?

No, but much less effort is needed to control the risks than arbitrage strategies face, since profitable trades occur regardless of market movement or volatility exposure. In other words, the common risks associated with naked stock positions are gone.

Liquidity, price impact, and transaction costs (associated with the size of transactions) are generally made manageable through proper calculations. Mathematical finance helps optimize arbitrage strategies through things like linear programming or vector space representations, but to get basically profitable (just not maximized), anyone with basic algebraic knowledge can handle it.

Do you need a large capital to apply arbitrage strategies?

No. There are many opportunities for traders of all account size levels. Although, of course, the larger the transactions, the more negligible the transaction costs become, making the rewards more attractive.

Quick example:

A New Zealand company is listed on both the NZSX and the ASX, and today at close you will see the following prices for the shares:

(hypothetical prices)

In NZSX: $10.00NZD/share

In ASX: $10.50NZD/share

You short 300 shares of ASX (requires $3,150 cash in the account), then buy 300 long shares of NZSX. When prices converge, you close both positions.

Total Initial Cash Requirement: $6,300

Total win: $150

Total transaction cost (at $30/exchange): $120

Total Net Profit: $30

At $30/trade, the brokers here charge too much, so arbitrage this way is not that attractive.

So with a few thousand dollars, anyone can make money in these markets no matter what the market moves.

Reasons why not all traders apply these strategies

Some just don’t get it or never bothered to look it up. Then, for others, the returns are still too low. While arbitrage strategies offer double-digit returns per year with very low risk, ambitious traders aim for much higher goals.

Exceptionally high returns require very active management and innovation strategies. Although once found, the aforementioned arbitrage models no longer seem attractive. I have known traders who earn more than 1% per day, consistently, so yes, anything is possible.