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May 5, 2009

Volatility Fuels Arbs' Profits

Arbitrage strategies make hay in down market

By James Ramage

Also in this article

Firms employing arbitrage strategies have been ringing the cash register over the last eight months.

Their main allies have been volatility and wider spreads. The incredible price swings in early April, for example, showcase the environment in which these strategies have been successful.

On April 2, the Chicago Board Options Exchange's Volatility Index--or VIX--registered in the low 40s at the end of the day. More than 13.5 billions shares were traded.

And the Dow Jones Industrial Average climbed 214 points. For those traders, and particularly the high-frequency market makers, who make money on the small differences in price between highly correlated stocks, the price swings have been good business.

"[April 2] was definitely a volatile day," said Will Sterling, global head of direct execution at UBS. "And I'm sure it was a good day for high-frequency market makers."

Arbitrage trading strategies, which profit from small pricing discrepancies typically by buying one instrument and selling another highly correlated security, are hot right now. They benefit market liquidity and there's money to be made using them, industry experts say.

Wider Spreads

These strategies have thrived over the past seven months or so because the turmoil in the markets has kept volatility high and spreads wide. It has also forced a large number of market participants to the sidelines, or out of the game altogether--primarily the proprietary trading desks at the bulge bracket firms and hedge funds.

As a result, the markets have been operating less efficiently with the wider spreads. And these conditions favor arbitrage strategies that capitalize on the temporary price discrepancies.

"We have seen an uptick in both portfolio rebalancing and pairs trading," said Andrew Silverman, head of sales and distribution for electronic trading at Morgan Stanley.

Some common arb strategies include:

Risk/merger: Employed around the merger of two companies. It can involve buying the acquired company and selling the acquiring company.

Statistical: High-volume, low-margin and model-driven. Stat arb strategies take a short-term look--ranging from intraday to 10-day--at highly correlated stocks' prices. Similar to pairs.

Andrew Herriott, CA Cheuvreux


Pairs trading: Looking for corrections in the prices of two highly correlated companies that have sudden discrepancies--e.g. buying Coke and selling Pepsi when the latter's price has climbed.

Exchange-traded funds: The strategy's popularity stems from ETFs' popularity. Employed to profit from a misalignment between an ETF's trading price and the value of its underlying securities.

Among the arbs, sources tell Traders Magazine, are hedge funds such as Hudson River Trading; high-frequency market makers, such as Chicago-based broker-dealer GETCO; and proprietary shops such as Los Angeles-based broker-dealer EWT Trading.

Volatility has been the primary engine behind the strategies' popularity. Conditions are generally considered volatile when the VIX measures at least 25.

By last May, the year 2008 was shaping into one of the most volatile since the Great Depression. The VIX was clearing 25 routinely, and even hit 32.24 in March after Bear Stearns fell.