Stock Arbitrage: Tread Carefully and There Are Profits to be Made

When people think of Warren Buffett, the greatest investor of all time, they often focus on his knack for picking cheap stocks, or the extra free leverage gained by his massive insurance operations, or even Berkshire Hathaway’s new focus of buying whole companies to add to its already impressive empire.

What doesn’t get much attention is Buffett’s skill in stock arbitrage, a skill which has accounted for a surprising amount of his ability to generate wealth.

What exactly is stock arbitrage and how do investors use it to make money? Let’s take a closer look.

The basics of arbitrage

Arbitrage is the act of buying in one market and selling in another, taking virtually guaranteed profits in the process.

Say the price of gold was $1,000 per ounce in London and $1,005 per ounce in Paris. Since gold is gold no matter where it trades, a person could make a risk-free profit by loading up on gold in London and then selling it immediately in Paris.

Since information now moves so quickly, these types of situations never happen anymore. However, investors can still make money on stock arbitrage by investing in events that have a very high likelihood of happening.

The easiest situation is a friendly acquisition, like a company buying a competitor. Say shares of the competitor trade at $20 per share before the offer comes in. The acquiring company offers $30 per share, and everyone is happy with the deal. Closing is expected to take approximately six months.

In response, the market bids up shares of the target company to $28 per share. There are two reasons why shares don’t immediately trade at $30 each. Firstly, there’s a small chance the deal gets scuttled somehow. Perhaps regulators don’t like the amount of market share this new company will have. Or maybe the buyer’s financing is somewhat sketchy.

The other reason is because of the time value of money. Investors need a compelling reason to put their money into an opportunity. Without being compensated for both the risk and locking up capital that could be put to other uses, arbitrage opportunities wouldn’t exist.

A cash offer is the simplest arbitrage opportunity. Often, instead of offering cash for their prize, an acquiring company will offer a combination of cash and shares, or just shares. Investors can still make money on these sorts of arbitrage deals, but they’re much more complicated. I’d recommend leaving these deals up to the professionals.

Making money on arbitrage deals

There are two keys to making money on these kinds of situations.

Firstly, an investor has to be nearly 100% sure a deal will go through. It takes a lot of successful arbitrage transactions to make up for just one that goes badly.

You have to look at the details of the deal to determine the chances of success. A company with a controlling shareholder who wants the deal to happen is a good thing, for obvious reasons. So is a deal where everyone knows the company being acquired was for sale.

The ability of the acquiring company to buy should also be scrutinized. If a company agrees to pay $100 million for a competitor and it has $150 million in cash on its balance sheet, the deal is much more secure than if the same company has to borrow the $100 million.

Often, a company that needs to borrow the money for an acquisition will talk to bankers before the deal is even announced. Then the company will announce with the deal that financing is already in place. This is a good thing, almost as good as having the cash on hand.

But on the other hand, a company might have no idea where they’re going to get financing once an acquisition is announced. That could be bad news for the deal’s completion, which is what arbitrage investors want to avoid.

What kind of returns?

These days, depending on the deal, investors can expect about a 10% annual return on what I’d call safe arbitrage situations. Returns much greater than 10% annually are out there, but they’re from deals the market thinks are risky.

Generally, investors should be waiting until only a month or two before a deal is scheduled to close. Yes, returns are lower–at least compared to four or six months out–but these deals tend to have a higher completion rate. The key to successfully pulling off this strategy is minimizing losses, not going for the best gains.

Answers to the Most Frequently Asked Questions About online trading

Online trading has become very popular because it is a way of making money. Despite its popularity, there is still a lot that people don’t know about forex trading. CMC Markets would like to help you make wise decisions when it comes to matters of online trading. If you are a beginner and would like to learn more about online trading, read through the answers to these frequently asked questions.

What is online trading?

Online trading is a form of trading financial securities such as bonds and stocks, financial derivatives or foreign exchange electronically. Advancements in technology make it possible for people to buy and sell these securities through an electronic platform and network. There are numerous virtual markets where people trade online. They are commonly referred to as Electronic Communication Networks.

What is the difference between online trading and day trading?

A common misconception about online trading is that it is the same as day trading. The difference lies in the methods used. In online trading, an investor buys and sells securities via the internet while day training is about speaking with a broker by telephone. An individual makes transactions on the same day.

What are the advantages of online trading?

Online trading is the fastest method of trading. Since investors use computers to make transactions, it gets done so quickly. Information technology has given rise to high-speed internet connections and computers. It means that you can easily trade stocks, bonds, currencies, futures or options online.

Secondly, online trading has improved the speed at which transactions can be made and settled. Initially, people had to deal with a lot of paperwork. It took long for the documents to be copied. Now they can just be filed electronically.

How can I become an online trader?

It is so easy to begin trading. All you need is a computer and some money enough to open an account. It is one of the best methods of investing especially if you have a good financial history. However, this doesn’t mean that you must have a disposable trade or a personal broker to do it. The virtual markets have become more accessible. Despite this, there is a still a lot that an online trader has to consider. The first step is to choose a stockbroker.

Before you begin, educate yourself about the twelve different types of trade that can be placed. These include market orders, limit orders, All-or-none orders, day and GCT orders, extended hours trading, trailing stop orders, bracketed orders, selling short and buy to cover orders, and stop order and stop limit order. Familiarize yourself with all these types of orders so that you can understand how the market works. It is important because it will help you avoid making big and expensive mistakes.

Are there risks in online trading?

Any method of trading securities has some risks of potential losses. It doesn’t really matter if you are doing it online or not. If you are new to this business, take some time to understand the principles. What are your investment goals? Also, think about your own risk tolerance. Another factor that may affect your ability to execute transactions is high internet traffic. Try to avoid the temptation to ‘overtrade’ as it can have negative repercussions.

What is the meaning of “trade on margin”?

You will have to open a margin account if you wish to borrow some money from a firm. There is a certain amount of the purchase price that you will have to deposit in the account. It acts as your initial equity. Trading on a margin simply means that you can purchase more securities. However, you have to fully understand this concept since there are risks of incurring losses.

How do I open an account online?

There are many brokerage firms online that you can open an account with. To activate an account, you have to sign an application document. Some firms allow you to do this electronically while others demand a hand-written one. Ensure that you understand all the specific guidelines.

How long does it take for an order to be executed?

If you are doing it electronically, the process is fast. However, there may be delays especially if there are high trading volumes. A delay can cause a significant difference in the price. The speed at which an order gets executed also depends on the firm’s level of access. If their system is complicated, the process may be slow. Also, ensure that the speed of your internet connection is fast as this may impact on the speed of transaction.