Explain it to me like I am a 5-year-old: Basic Trading Strategies (Arbitrage, Hedging)

I am a graduate student pursuing a Masters in Computer Science from NYU wanting to understand finance and many of the underlying concepts. This post is meant for people who are completely new to Finance but want to have a basic understanding of the stock market. My aim here is to make the concepts easier and more understandable.


Arbitrage:



Let’s say you are a salesperson who wants to sell earphones but you are not aware of the price range for your area so you go to a market near your house and find the price of 1 set of earphones to be $10. Now you go to another market, a little far from your house and see that the price of 1 set of the same earphones is $15.


Why is there a difference in the price of the same set of earphones in two different markets? Because of different people with different backgrounds and different thinking buying from different markets which in financial terms is called market inefficiency. How do you make a profit from it? You buy earphones from the market where it is being sold at $10 and sell it for $15 in the market where it's worth $15. Thus you make a profit of $5/set of earphones. This is what we call as arbitrage. It is the profit that we get from the price differences of identical financial instruments on different markets or different forms.


Arbitrage takes place when security is bought in one market and is sold in another market at a higher price which is basically risk-free trading. But nowadays because of computerized trading, these arbitrage opportunities are easily detected by computers and are vanished in seconds. There are two main types of arbitrage: Pure and Risk.


Pure Arbitrage is a risk-free arbitrage. Let’s say a stock of company X is being sold at Bombay Stock Exchange for $50 while the same company’s stock is being sold at New York Stock Exchange for $50.50. Here the trader can buy the stocks from Bombay Stock Exchange for $50 and sell it at the New York Stock Exchange for $50.50 making a profit of 50 cents. This is an example of Pure Arbitrage which is risk-free as you are confident about making a profit.


Risk Arbitrage is speculative meaning it depends on future events which may or may not happen hence it involves risk. Let’s say a Dena Bank’s stock sells for $10 while Bank of Baroda’s stock sells for $15. If you think that there is going to be a merger between Bank of Baroda and Dena Bank then you can buy 100 stocks of Dena Bank for $1000 (10 x 100) and once it merges with Bank of Baroda, you can sell the 100 shares for $1500 (15 x 100). As you can see, here the profits depend on the merging of the two banks. If they don’t merge then there might be a loss hence it is called a Risk Arbitrage.


Hedging:



Consider you buy a vehicle in a city which is prone to accidents. A company tells you that in case of any accidents, we will cover all your expenses but for that, you need to give us a certain amount of money every month. This is basically how insurance works. Here just by paying a certain amount every month, you have reduced your risk of paying after the accident. This is you hedging against accident. Hedging is basically reducing or eliminating the risk but at a certain cost. Hedging is not free. In terms of your vehicle insurance example, if there happens to be no accident with your vehicle, your monthly payments to the company won’t be returned to you.

A perfect hedge is the one that reduces 100% of the risk in your portfolio. The most common way of hedging is by Derivatives. These include futures, forwards, swaps and options which I have explained in my previous post. Derivatives provide a good way to hedge against the underlying asset. People usually use Derivatives in their trading strategy to reduce the risk in their investment.

Let’s say you bought 100 shares of Company ABC for $20 each. To reduce the risk of losing all your money, you can buy a Put Option (explained in the previous post) for $10 which has an exercise price of $15 and a duration of 1 year. Which means that you can sell shares of Company ABC for $15 anytime within the next 1 year no matter what the stock price is of Company ABC. So if the stock price after a year is $25, you won’t use your Put Option and you will lose $10(price of the option) but gain $500 ((25–20) x 100). But if the stock price after a year is $0, then you will use your Put Option where you can sell your shares at $15/share even though the current price is $0. As you can see, buying a Derivative can help reduce the risk of losing all the money.

Another way to hedge can be through diversification. Let’s say you buy stocks from the technology sector. To hedge/reduce the risk, you also plan to keep stocks from the oil & gas sector in your portfolio. This strategy has its own tradeoffs. If employment is high and there is a good flow of money, people would buy more electronics and the stock price of technology sector might go up but meanwhile, there might not be such a great interest in the oil&gas sector which might reduce the stock price of that sector. Also, it might not always be the case that both sectors are inversely related. It can happen that both the sectors go down at the same time as happened during the financial crises. These are the two basic trading strategies that are used by the traders.


That’s it for this post. Do check out my other posts to gain more knowledge about finance. Please do let me know if there is any other concept in finance you want me to write an article on, I will try my best to explain it in simpler terms.

Also, feel free to ask questions in the comment section. Will be happy to help you out :) Happy to connect on LinkedIn.

PS: The analogy I have used might not be 100% correct but it’s easy to understand things with a simpler analogy. I read related articles from different sources like Investopedia and try to explain it in a simpler manner.

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