An arbitrage trading program (ATP) is a computer program that seeks to profit from financial market arbitrage opportunities. These opportunities occur from financial market mispricings which can be profitable when traders take positions on underlying securities such as stocks or commodities, or derivatives based on them.
Arbitrage trading programs are driven by customizable algorithms that can scan market prices and identify pricing anomalies in a matter of milliseconds (sometimes referred to as an “electronic eye”). These systems can be programmed to identify a wide array of potential trading opportunities and automatically execute trades to take advantage of arbitrage opportunities when they arise.
Arbitrage opportunities don’t usually last long, therefore computers are more efficient at finding the opportunities and quickly exploiting them compared to humans.
ATP software can be utilized by both individuals and institutional clients, but is most often employed by professional traders.
Arbitrage is the simultaneous purchase and sale of the same asset in different markets in order to profit from tiny differences in the asset’s listed price. It exploits short-lived variations in the price of identical or similar financial instruments in different markets or in different forms. Arbitrage exists as a result of market inefficiencies and it both exploits those inefficiencies and resolves them.
Arbitrage trading programs are executed via program trading, or trading by automated computer systems that follow predetermined orders or algorithms. These computerized trading systems are able to identify brief instances of mispricing, and place trades while there is an opportunity to profit from arbitrage.
High-frequency traders are a subset of arbitrage and program trading, as these traders attempt to profit from order flow, very quickly, resulting in arbitrage-like opportunities. Approximately 50% (subject to change) of the trading that occurs on US stock exchanges is high-frequency program traders as of 2018.
Arbitrage trading programs seek to identify and exploit all types of profit opportunities in the financial markets based on advanced algorithms.
Arbitrage opportunities typically only exist for a short amount of time. Thus, the use of technology programs can help to identify and act on trading opportunities more rapidly. Arbitrage opportunities often occur in cross-border trading activities where mismatched pricing results from thin communication channels. For example, a company that is dual-listed on the Bombay Stock Exchange in India, as well as the Frankfurt Stock Exchange in Germany should have the same stock price when adjusting for exchange rates, but if the prices don’t align, an ATP program can calculate the discrepancy and then make trades to close the gap in prices, attempting to make a profit from the mispricing.
Many traders also use options and futures in arbitrage trading programs. This may require the trading system to take two market positions on an underlying asset that they believe is reporting profit potential. One example could include buying grain on the open market and simultaneously buying an option to sell grain in the future. If the price of grain increases over the investing interval, then the investor profits from the difference.
Institutional traders or market makers have several advantages over retail traders in relation to arbitrage trading, including faster news sources, high-performance computers, and more sophisticated arbitrage trading software programs. Regardless, arbitrage trading remains popular with many traders.
Institutional investment managers may use an ATP as part of a specific investment strategy. Arbitrage investment strategies may focus on foreign exchange trading, mergers, or event-driven arbitrage opportunities. While the strategy goes in and out of favor, some institutions will buy companies that are involved in a pending buyout.
Risk arbitrage (risk arb), also known as merger arbitrage, is an investment strategy to profit from the narrowing of a gap of the trading price of a target’s stock and the acquirer’s valuation of that stock in an intended takeover deal. In a stock-for-stock merger, risk arbitrage involves buying the shares of the target and selling short the shares of the acquirer. This investment strategy will be profitable if the deal is consummated. If it is not, the investor can lose money.
As an example, say that the announced buyout price for a takeover candidate’s stock may be $50, yet the stock trades in the market at $45 prior to the deal being finalized–since there is a risk that the deal may fall through. Institutions will analyze the deal, possibly using programs, and then buy the deals that are likely to close. In this case, if the deal goes through, they make 11% ($5/$45) in a matter of weeks or months. This strategy would likely utilize both an ATP and manual human research.
Another example of arbitrage-style investing is index arbitrage. This where an ATP is designed to buy stocks that are being added to a major index. An index such as the S&P 500 will announce in advance what stocks they are adding or dropping from the index. The index will buy shares of the added stocks and sell shares of the dropped stocks. Also, an index adding a stock tends to increase that stock’s visibility and status, which may also help elevate the price.
ATP programs are therefore set to start buying the stocks which will be added to the index once the announcement is made. The ATP programs are attempting to get in ahead of the move up in price which is likely to occur as a result of the index having to buy shares and the bolstered status of the shares among other investors.
As the price pushes up based on the increased demand, the ATP begins selling the shares as the program is designed to take advantage of the specific event, and not trade the stock on its own merits necessarily. Therefore, the ATP quickly buys shares when demand for the shares is increasing due to a specific announcement event, and it then sells the shares, hopefully at a profit, as the event comes to a close or the demand from the event begins to dry up.