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Stock arbitrage involves buying and selling shares of the same or similar stock to make a net profit. Traditional arbitrage involves no risk, while variations like merger and pair trading involve some risk.
Stock arbitrage is the buying and selling of shares of the same or similar stock with the goal of making a net profit on the transaction. In its purest form, stock arbitrage involves no risk, as the buying and selling are done simultaneously, guaranteeing an immediate profit. Variations of traditional stock arbitrage, sometimes called risk arbitrage, often involve at least a small amount of risk, as they deal with situations where profit is not guaranteed.
Traditional stock arbitrage involves buying and selling shares of the same stock at different prices in two different markets. For example, suppose a company has shares that sell for $10 US dollars (USD) on the New York Stock Exchange. Shares of the same company are $11 USD on the London Stock Exchange. To take advantage of stock arbitrage in this situation, an investor could buy shares of the company on the New York Stock Exchange and simultaneously sell them on the London Stock Exchange to make a profit of $1 USD per share. Since the buying and selling are done at the same time, there is no risk of losing any money.
A variation of traditional stock arbitrage, commonly called merger arbitrage, involves buying and selling shares in two companies that are about to merge. An example of this would be if Company A has a share price of $50 USD and is preparing to take over Company B, which has a share price of $24 USD. As part of the deal, Company A agrees to give Company B’s shareholders one share in Company A for every two shares they own in Company B. An investor who owns shares in Company A could apply stock arbitrage to this situation by selling Company A shares and buying Company B shares in their place, hoping to make a profit on the $2 USD price difference when the companies merge. The risk in this type of situation is that the merger deal could fail or that values could change rapidly.
Another variation, sometimes called pair trading, involves buying and selling shares of very similar stocks that have historically priced very closely, but which suddenly develop a more significant price change. For example, suppose the shares of Power Company X and Power Company Y typically trade within a few cents of each other. If Company X’s stock suddenly rises $1 USD above Company Y’s stock, an investor who owns Company X’s stock could sell it and put the money back into Company Y’s stock, looking to make a profit when Company Y’s stock they achieve Company X’s price, as they have historically. Like merger arbitrage, this type of stock arbitrage usually involves some risk, as there is no guarantee that Company Y’s shares will rise in value to match those of Company X.
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