If you are a market maker or an institutional investor, you may be able to take advantage of true arbitrage.  This is a risk-free trading tactic that profits from the price differences between the different markets and exchanges.  Risk arbitrage requires instant market information, and the ability to sell in high volumes.  After all, a difference of a few cents per share will not equal maximum profit unless you are trading in high numbers.

However, there are still ways that individual investors can make money on arbitrage, though they do not enjoy the benefits of completely risk-free investments.  By using the basics of arbitrage, you can develop a strategy to make the most of market discrepancies.

Learning from the Benjamin Graham

Benjamin Graham’s risk arbitrage formula allows one to estimate the potential of a particular play.  The indicated annual return is found by subtracting the expected chance of success from 100% and multiplying the result by the expected loss in the event of a failure.  You then subtract this number from the expected gain multiplied by the expected chance of success, and divide the total result by the time of holding multiplied by the current price.

Strategies for risk arbitrage

There are a variety of strategies that you can utilize to profit from the consumer’s version of risk arbitrage.  This does mean using the same market basics that true arbitrage uses, but with what is available to you personally.
The most common type of arbitrage is the merger and acquisition arbitrage.  This means researching companies that are underrated, who are targeted for acquisition.  When a takeover is announced, the price then goes up to the true value of the stock.

You can also watch for a liquidation arbitrage.  When the current share price is lower than a company’s book value or its net assets, it is a good candidate for an arbitrage strategy.  A company may choose to liquidate some or all of it assets, meaning that your stock could profit.  On average, voluntary liquidations of undervalued stocks allow shareholders to see a profit of over 40%.

The least common type of arbitrage is relative value arbitrage.  Also known as pairs trading, it is best used in sideways markets.  You purchase a pair of stocks that are very similar, often in the same industry and with similar business histories.  When the stock prices between the two differ by 5-7% for several days, you may choose to go long or short on one of the stocks, earning a profit when the prices come back together again.

Timing is critical

In order to profit from risk arbitrage, you have to monitor streaming news and know exactly when to act so that you can beat out other investors.  Check with your brokerage, as they will often offer real-time newswire services that are more up-to-the-moment than other news sources.

Your timing is one of the most important aspects of risk arbitrage strategies, and it may be in your best interest to have Level II access trading, allowing you to trade almost instantaneously.  In addition, this will also allow you to see the other orders waiting to be filled, allowing you to obtain a better feel for the supply and demand for shares.

You may not be able to take advantage of risk-free arbitrage as a retail investor, but you can use the same fundamentals to earn a profit.  By learning to stay ahead of other investors, you can reap many of the same returns at a significantly reduced risk level.