Equity arbitrage is the buying and selling shares of the same or similar stock with the goal of making a net profit on the transaction. In its purest form, equity arbitrage involves no risk, as the purchase and sale are made simultaneously, ensuring an instant profit. Variations of traditional equity arbitrage, sometimes called risk arbitrage, often carry at least a small amount of risk, as they deal in situations where the profit is not guaranteed.
Traditional equity arbitrage involves buying and selling shares of the same stock that is priced differently in two different markets. For example, say a company has shares that are selling for $10 U.S. 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 could buy shares of the company’s stock on the New York Stock Exchange and simultaneously sell them on the London Stock Exchange to make a $1 USD per share profit. Because the purchase and sale are made at the exact same time, there is no risk of losing money.
One variation on traditional equity arbitrage, commonly called merger arbitrage, involves buying and selling shares of two companies that are about to be merged. An example of this would be if company A has a share price of $50 USD and is preparing to buy out company B, which has a share price of $24 USD. As part of the deal, company A agrees to give company B shareholders one share of company A for every two shares they own in company B. An investor who owns shares of company A might apply equity arbitrage to this situation by selling off company A shares and buying shares of company B in their place, hoping to make a profit on the $2 USD price difference when the companies merge. The risk in this type of situation is that the merger deal might fall through or values change rapidly.
Another variation, sometimes called pairs trading, involves buying and selling shares of very similar stocks that have historically been priced very closely, but suddenly develop a more significant price variance. For example, say electric company X and electric company Y stocks typically trade within a few cents of each other. If company X’s shares suddenly rise $1 USD over company Y’s, an investor who owns company X stock could sell it and an reinvest the money in company Y stock, looking to make a profit when company Y’s shares catch up in price to company X’s, as they historically have. Like merger arbitrage, this type of equity arbitrage also usually carries some risk, as there is no guarantee that company Y’s shares will increase in value to match company X’s.