There are tradable assets such as commodities and commodity futures, stocks and stock futures, and foreign currencies that trade on more than one market. The prices on these markets move up and down according to the same fundamental and technical factors. But they do not necessarily move in lockstep. Very commonly during the trading day price, discrepancies emerge between the same or related assets between two or more markets. For the prepared and disciplined day trader, these are potentially risk-free arbitrage opportunities in these financial markets.
Statistical Arbitrage
Managers of large portfolios can engage in what is referred to as statistical arbitrage. This approach is not necessarily without risk as it relies on mean reversion or the tendency of the market to depart from and then return to predicted or historical norms. With this approach traders commonly open both long and short positions on the same or related assets. A commodity futures trader may, for example, look for arbitrage opportunities in crude oil futures or they may seek arbitrage opportunities between futures on crude oil versus futures on the US dollar. The degree to which a day trader profits from this approach will depend upon their choice of assets and the discipline with which they enter, manage, and exit their trades. For those who rely entirely on statistical analysis, the results will depend upon the quality and accuracy of their trading software!
Merger Arbitrage
As with all day trading, there are times when markets are tranquil and times when they are volatile. Recognizing situations that may be more likely to provide profit potential is a valuable day trading skill. One of these situations occurs in stock and stock futures trading when acquisitions and mergers are on the horizon. These are situations where the old saying, buy on the rumor and sell on the news often applies. The market can get overly excited about the prospects of dramatic price changes of either the company doing the takeover or the company being taken over. Because such deals may go through or may be suddenly scrapped, traders are wise not to hold onto positions for longer time periods without constant attention. Nevertheless, a disciplined day trader can make handsome profits doing what is essentially merger arbitrage at such times.
Currency Arbitrage
Foreign currency trading occurs during trading (daylight) hours in New York, London, Tokyo, and Sydney. To the extent that their hours overlap, a day trader can use arbitrage to benefit from the price differential of a given currency pair in one market versus another. These price differences are temporary as the same fundamental and technical factors come to bear no matter which market one is trading. Alternatively, different markets may not be offering price differentials but different brokers may be offering different spreads either in the same market or different markets. With constant attention to detail and a disciplined approach this can be a way to find risk-free trading opportunities.
Pairs Trading
There are commodities, stocks, and currency pairs that tend to have strong price correlations. That is, they may tend to go up together or move in synchrony but in opposite directions. Some of these relationships make sense like crude oil futures and futures on the S&P 500. Others, like the relationship between the Nasdaq and Bitcoin may leave you scratching your head. The point is that there are many asset pairs that lend themselves to successful arbitrage trading. In order to do this successfully, a day trader is wise to first identify such pairs by looking at historical data. Then the disciplined day trader will practice trading the pair in simulation with spread calculations, risk management techniques, and cointegration until they are routinely seeing profits “on paper.” Only then should they be risking their own trading capital in live trading.
Arbitrage Risks
If arbitrage were always successful that is how everyone would day trade. The fact that they don’t tells you that making this profitable takes thought, effort and close attention to detail. There are execution delays to consider when price differentials occur and then disappear. There are always liquidity risks where one is not sufficiently quick in executing a trade and gets trapped in a losing position. The most successful day traders in arbitrage generally look to maximize the risk-free aspect of their trades and not aim for excessive profits. Maintaining risk-free conditions requires prompt trade execution and always setting one’s stop-loss and take profit targets on every single trade.