What the Heck is Arbitrage, Anyway?

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Today’s Bullets:

What is arbitrage?
Where do you see it?
Why should you care?
Anything else you need to know?

Inspirational Tweet:

Market neutral arbitrage has been and will continue to be the gate way for a lot of institutions to take directional Bitcoin positions.

In the same light, expect the market to continue to become more efficient as these participants enter.

— Will Clemente (@WClementeIII) February 12, 2022

Will is pointing to the fact that institutional money managers (hedge funds, in particular) are taking long/short paired positions in Bitcoin-based securities and trading around them to profit. This is a form of what we call ‘arbitrage’ on the Street.

BTW, if you are into Bitcoin and want to understand trends in how people are buying and holding coins, Will is a great analyst to follow.

🤔 So what the heck is arbitrage, anyway?

Put simply, it is the ability to take advantage of market price inefficiency.

You buy an item at one price and simultaneously (this is the important part!) sell the same or interchangeably same item at a higher price, thereby creating a guaranteed profit for yourself.

For example (ignoring tax and shipping to simplify):

You go to Best Buy and see they are having a one-day sale on Apple watches. Marked 25% off, they are selling for $300.

But you know that they are selling for $375 *Brand New* on eBay.

You pull out your phone and quickly whip up an offer on eBay for $375 and instantly sell a watch.

As you sell that watch, you buy the same watch for $300 at Best Buy.

You then send the watch you bought for $300 to the person who bought it from you at $375, and you pocket the difference.

An instant $75 profit.

This is arbitrage.

🧐 Where do you see it?

You may not notice it, but it is happening all around you, especially in the financial markets:

Foreign currency and bonds produce what is called ‘interest rate arbitrage’: Exchanging one currency for another to buy foreign bonds, then using a future contracts to sell the same trade at better exchange rates and/or interest rates.
Mergers and acquisitions create ‘merger arbitrage’: Buy stock in the company that is being acquired (the target), and short the company who is the buyer (the acquirer). When the merger closes, the target shares become the acquirer shares, thereby making the trade collapse, and you collect the difference.
Spot and futures markets create ‘cash and carry arbitrage’: Buy spot commodity at one price while simultaneously selling short commodity futures at a higher price, and when the spread narrows, you collect the profit.

🤨 Why should you care?

Well, since many of you I know are Bitcoin investors, this is happening right under your noses. How? The cash and carry version in the third example above. Here’s how it works:

Investor sees that GBTC is priced much lower than the BTC Futures ETF. So investor does the following:

Sells BTC Futures ETF short,
then, using the money received from that short sale, he then buys GBTC at a lower price,
and when the spread narrows, he exits the trade.

Essentially free money.

This is also why we need a Bitcoin Spot ETF. But that’s to explore in another newsletter…

💡 What else do you need to know?

Well, what Will Clemente is talking about in his Tweet above is exactly what I just laid out in the cash and carry example.

And so:

“Market neutral arbitrage” is another way of saying cash and carry.

“…will be a gateway for institutions” = hedge funds will use the trade.

“…to take directional Bitcoin positions” = traders will either cover or add to the short or cover or add to the long, depending pricing and which way they think Bitcoin is positioned to move. If they think Bitcoin is at a low point and poised to move higher, then they will cover some of the short or add to the long, and thereby lean long. If they think it is overbought, they will add to the short or sell some of the long and lean short, hoping the price moves lower.

“As more participants enter” = the spread will tighten and the markets will therefore be “more efficient”.

That’s it. I hope you feel a little bit smarter knowing what arbitrage is and empowered to take advantage of similar market opportunities in your world.

Feel free to respond to this newsletter with questions or future topics of interest!

✌️Talk soon,
James