- Easy profits on the VIX.
- Bannon’s firing triggers the latest payday.
- Does the VIX trade qualify as arbitrage?
The VIX trade has been among the easiest trades on Wall Street for nearly a decade.
Also known as the “Fear Index,” the VIX is the foremost measure of market sentiment.
A nervous market sends the VIX soaring.
A complacent market holds the VIX down, which has mostly been the case since the Fed announced a second round of quantitative easing, buying $600 billion of Treasury securities in 2011.
During this period of a flat-lined VIX, the winning trade has been very simple…
Buy call options on the VIX when it dips under 10, and then sell them when an upward blip occurs.
For the umpteenth time on Friday, the VIX trade paid off.
This time, the index spiked on news that Steve Bannon was fired.
Expect the VIX to go back into hibernation over the next few days.
Lather. Rinse. Repeat.
With the likelihood of winning easily over 90%, does the VIX trade constitute an arbitrage opportunity?
Not quite.
Investopedia defines arbitrage as follows…
Arbitrage is the simultaneous purchase and sale of an asset to profit from a difference in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Arbitrage exists as a result of market inefficiencies.
It’s virtually impossible to lose when a true arbitrage opportunity presents itself.
Fortunately, we have an arbitrage expert on staff — my senior analyst, Martin Hutchinson.
Martin H.: Good morning. It’s Martin Hutchinson, senior analyst for Wall Street Daily. I’m constructing a library of basic investment concepts that you need to have in order to make money.
Today, I want to talk about arbitrage. Arbitrage is the simultaneous purchase and sale of similar assets to take advantage of difference in prices. Pros set their computers to do this. So for example, they buy American Depositary Receipts (ADRs) in a Singapore company, even if they’re illiquid. Because the pros’ computers arbitrage the ADR on the underlying share in Singapore. They buy New York, sell Singapore… or sell New York and buy Singapore… and make a few pips on the price.
On the larger shares, prices in London, New York, Singapore and Tokyo are kept in line by these means.
So arbitrage is terribly useful for the ordinary investor because it keeps the price in New York in line with the price in the home country, if you’re buying internationally.
One example of arbitrage is pairs trading, which we’ve covered.
If there is a cash offer, you buy if the price is below the cash price. If it’s a share offer, you buy the seller and sell the buyer. Or the opposite. In both cases, you square the trade when the deal goes through, and that ensures that you’ve locked in a profit.
Another good arbitrage is asset arbitrage. You can buy Yahoo (NASDAQ:AABA), which is now called Altaba (NASDAQ:AABA) (AABA), and sell Alibaba (NYSE:BABA). Because AABA owns a chunk of BABA and not a lot else. You’ve essentially got an arbitrage between those two share prices.
Another arbitrage is tax arbitrage. For example, taxable and tax-exempt investors have different values for an interest payment or a dividend. If you’re tax exempt, you should buy bonds just before their interest payments (if you’re buying in an IRA, for example). You can do an arbitrage by buying a bond that’s paying interest, selling one that isn’t — and reversing the trade after the interest is paid.
So the bottom line is that merger and tax arbitrage can be profitable even for individual investors and are not risky.
Even when you’re not doing arbitrage directly, think through arbitrage possibilities to see if you can do a trade in a cleverer way. For example, should you buy AABA or BABA — one is always better than the other.
Short selling is more expensive for individuals than institutions and hedge funds, so be sure you’ve taken this into account when deciding on an arbitrage trade.
But even so, arbitrage can provide you with good opportunities, and the arbitrage mindset is very helpful to you in thinking about your investments in general.
This is Martin Hutchinson signing off.
Smart investing,