Equity arbitrage is the purchase and sale of shares of the same or similar stock for the purpose of making a net profit on the transaction. In its purest form, equity arbitrage involves no risk, since buying and selling take place simultaneously, ensuring an instant gain. Variations of traditional equity arbitrage, also called risk arbitrage, often carry at least a small amount of risk as they trade in situations where profits are not guaranteed.
Traditional equity arbitrage involves buying and selling stocks of the same stock that are priced differently in two different markets. For example, say a company has stocks that sell for $ 10 US Dollars (USD) on the New York Stock Exchange. The same company’s stock is $ 11 USD on the London Stock Exchange. To take advantage of equity arbitrage in this situation, an investor can buy shares in the companyâ € TMs stock on the New York Stock Exchange and at the same time sell them on the London Stock Exchange to make a $ 1 USD per-share profit. Because buying and selling are done at the exact same time, there is no risk of losing money.
A variant of traditional equity arbitrage, commonly called merger arbitrage, involves buying and selling shares in two companies that are being merged. An example of this would be if Company A has a share of $ 50 USD, and is ready to buy out Company B, which has a share price of $ 24 USD. As part of the agreement, company A agreed to give the company’s B shareholders one share of company A for every two shares the shareholder owns in company B. An investor who owns shares in company A could apply equity arbitrage to this situation by sell out of the company’s A-shares and buy shares in company B in their place, hoping to make a profit of $ 2 USD price difference when companies merge. The risk in this type of situation is that the merger deal may fall through or values change quickly.
Another variation, also called pair trading, involves buying and selling stocks in very similar stocks that have historically been priced very carefully but suddenly develop a larger price variance. For example, say Electric Company X and Electric Company Y shares typically trade within a few cents of each other. If Company XA’s shares suddenly rise $ 1 during Company YA €’s, an investor who owns Company X Stock can sell it and reinvest the money in Company Y Stock, seeks to make a profit when Company YA’s shares are acquired at price to company XA € s as they historically have. Like merger arbitrage, this type of equity arbitrage also usually carries some risk, as there is no guarantee that the companyâ € TMs shares will increase in value to match company XA € s.