Relative value arbitrage is an investment strategy that looks to take advantage of discrepancy in the prices between related financial instruments, like stocks and bonds, by buying and selling different securities simultaneously.
Before we begin to explain that, let us quickly review the idea of arbitrage – at its most simplest, it engages in the buying of securities at one market and reselling them at another market, so that you can profit from the discrepancy in prices.
What is relative value arbitrage?
In the hedge fund world, arbitrage usually refers to the concurrent purchase and sale of two securities with similar prices that, in the trader’s opinion, are not priced as low/high as they should be. Based on this assumption that prices will return to their true value over time, the trader short-sells the security that is overpriced and buys the security that is underpriced.
Once prices return to their true value, the trade can then be liquidated for a profit. Keep in mind that short selling is the borrowing of a security you don’t own and selling it in hopes that it will decline in value. At that time, you can purchase it back at a lower price and then return the borrowed securities.
Relative value arbitrage is also called “pairs trading” because, with relative value arbitrage, an investor invests in a pair of securities that are related. In an ideal world, these securities would have a high correlation, meaning that there would be a tendency to move in the same direction at the same time.
What exactly can you trade?
Stocks within similar industries that have similar length trading histories are often used in relative value arbitrage. Automotive stocks Ford and GM, as well as pharmaceutical stocks Pfizer and Wyeth, are good examples.
Indices, like Dow Jones Utilities Average or S&P 500 Index, can also be used in relative value arbitrage, and so can index tracking stocks, like SPY (tracks the S&P 500 Index) and QQQQ (tracks the Nasdaq Composite Index). When it comes to selecting securities, there is no limit: relative value arbitrage works with stocks, currencies and commodities, and futures options.
Is relative value arbitrage right for you?
When one security rises in value while the other security falls, the relative value arbitrageur buys one security while shorting the other. When the prices converge again, the trade gets closed.
Because relative value arbitrage needs the securities to be correlated in price, it typically uses sideways market, which is a market that doesn’t rise or fall, but trades within a specific range. Because of the associated risks, large institutional investors (i.e. private equity firms, investment banks, hedge funds) are the main users of relative value arbitrage.
While relative value arbitrage can aid in increasing returns in difficult market environments, like the sideways markets, it necessitates important expertise, and it is best left to the highly skilled investors who are ready to take risks.
Need more advice? Don’t hesitate to check out our complete guide to investing into stocks and bonds and learn how to anticipate market movements and navigate the trading field.