Be Your Own Arbitrageur

An arbitrageur is a person that takes advantage of price distortions in all different types of investment assets.  Now, this term is used when there are mergers & acquisitions going on.  It could be used with price discrepancies in a security that is being traded in multiple markets.  I think doing pairs trades can be a type of arbitrage.  These types of trades aren’t just for the big boys.

In this environment where you have to be creative in your trading, doing pairs trades where there are inefficiencies in prices can be profitable.  Let’s look at an example.  Typically, gold the commodity and gold mining companies generally are very correlated.  For several years, gold mining companies would generally outperform the commodity.  The reason was because these gold mining companies could use leverage, they could invest their own money wisely, so they were very profitable.  I’ve put a picture of gold & gold stocks below for the past year.  There were moving almost identically on a day to day basis.  Since the fall though, we’ve seen gold the commodity really take off.  I believe it’s because there’s been a huge demand for “real stuff” like gold and a fleeing from stocks, even gold stocks.

 

gold-vs-gold-stocks-3-9-09

We know that long-term correlations hold up but get out of line every once in a while.  So, what’s the trade?  Shorting the high one and going long the low one.  We don’t know if the high one will come down or the low one will go up.  But, we know the gap will close.  In other words, all things being equal, you can see from the chart that either gold should be trading at $825 or so or the gold mining ETF (GDX) should be trading at $47 (currently trading at $32). 

The obvious question is how soon will the gap close?  The answer is we don’t know.   That’s why it’s not a risk free trade.  But, eventually, it does close.  They all do. 

The easiest way to do this trade is to use ETFs to short gold and go long the miners.  DGZ is the short gold ETF and GDX is the long miners ETF.  That would be the easiest combination. So, you would buy both of them.  There are plenty of other trades like this out there right now.  When there’s this much fear and uncertainty and a collapse of this magnitude, opportunities arise.

This post published at www.karleggerss.com

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2 Responses to “Be Your Own Arbitrageur”


  1. 1 Bill March 12, 2009 at 2:35 pm

    Karl,

    on the same token, being your own arbitrageur, a similar behaviour for which I could still not make the sense, is MCD (McDonalds) and XOI (AMEX Oil Index). For 5 years, MCD has followed XOI (below but) move after move. In May 2008, XOI decreased to below MCD, and now with the inverse image (MCD above) they go in tandem. Plot it since March 2004 using linear graphs (instead of logaritmic).
    Having the picture in front of me the question is: what to do next. Any ideas?

    Bill, from Dallas.
    Hate not listening 2 U in the morning on the way to work.

    • 2 keggerss March 16, 2009 at 6:57 am

      I still like the oil companies and especially if we get a real rally money will probably come out of safe areas like MCD and go into more global growth areas like XOI. So, I’d believe the charts which means sell the MCD and buy the XOI. Stranger combination though.


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