Hey Folks. Happy Friday! After reading today’s blog you guys are going to do some homework for sure. Brain food is here!
What is Stock Arbitrage?
Stock Arbitrage started as a means of cashing in on the difference between the prices of same stock listed on different exchanges. So an investor wanting to take advantage of this discrepancies, buys stock from an exchange where it is at a lower value and hopes that the stock price will eventually catch up to the higher stock price in the other exchange. This is arbitrage trade and such a discrepancy in the prices of same security is short lived and only the most active traders will be able to take advantage of such an arbitrage trade.
On similar lines, an investor can take advantage of difference in stock price of Preferred Stock and Common stock. Such a trade has many advantages over the earlier arbitrage trade I have described
Let me introduce to Common Stock and Preferred Stock before we jump into this arbitrage.
A company issues common and preferred stock. Dividends for common stocks vary based on the company’s financial health and performance whereas generally all the preferred shares have a fixed dividend payment. Unlike to preferred stock, common stock has voting rights. In case of bankruptcy, preferred stocks holders are paid after common stock holders, bondholders and creditors.
Now getting back to the Common-Preferred Stock Arbitrage trade and its advantages.
Preferred stock generally trades at a lower volume than common stock. Although the same news generally applies to preferred and common stock, common stock tends to be very volatile and trades in greater volume. Take a look at the stock’s Beta (volatility compared to S&P 500) to know the difference between the volatility of preferred and common stock.
It is the common stock price which fluctuates quite a bit with positive or negative news. So in normal circumstances, the movement in the stock value of the preferred shares lags behind the movement observed in common shares. This lag in a few cases is not in seconds, minutes but also can be days or even weeks. So using this finite lag an investor who doesn’t keep a pulse on the market will get a chance to identify this discrepancy easily.
Any news about the company does apply to both preferred and common stock. So this brings us to another major advantage. An investor can predict the movement of preferred stock because it always follows the common stock which instantaneously tracks investor sentiment based on current news. Having said that, an investor must be really careful not to place such an arbitrage trade close to earnings, court ruling, board elections or any other news expected by that investor. Always remember that it is not the news but the way the market perceives the news that moves stock price. Such a trade placed by a vigilant investor will ensure that the common stock maintains the direction of its movement which the investor was tracking till the trade has been placed.
I am sure what the discussion above will open you eyes to a whole new area of investment strategy. Hold on now…before you place a bunch of money in preferred stock which lags commons stock be sure to try this strategy out with small or no money by tracking such shares.
Case Study 1
What is Stock Arbitrage?
Stock Arbitrage started as a means of cashing in on the difference between the prices of same stock listed on different exchanges. So an investor wanting to take advantage of this discrepancies, buys stock from an exchange where it is at a lower value and hopes that the stock price will eventually catch up to the higher stock price in the other exchange. This is arbitrage trade and such a discrepancy in the prices of same security is short lived and only the most active traders will be able to take advantage of such an arbitrage trade.
On similar lines, an investor can take advantage of difference in stock price of Preferred Stock and Common stock. Such a trade has many advantages over the earlier arbitrage trade I have described
Let me introduce to Common Stock and Preferred Stock before we jump into this arbitrage.
A company issues common and preferred stock. Dividends for common stocks vary based on the company’s financial health and performance whereas generally all the preferred shares have a fixed dividend payment. Unlike to preferred stock, common stock has voting rights. In case of bankruptcy, preferred stocks holders are paid after common stock holders, bondholders and creditors.
Now getting back to the Common-Preferred Stock Arbitrage trade and its advantages.
Preferred stock generally trades at a lower volume than common stock. Although the same news generally applies to preferred and common stock, common stock tends to be very volatile and trades in greater volume. Take a look at the stock’s Beta (volatility compared to S&P 500) to know the difference between the volatility of preferred and common stock.
It is the common stock price which fluctuates quite a bit with positive or negative news. So in normal circumstances, the movement in the stock value of the preferred shares lags behind the movement observed in common shares. This lag in a few cases is not in seconds, minutes but also can be days or even weeks. So using this finite lag an investor who doesn’t keep a pulse on the market will get a chance to identify this discrepancy easily.
Any news about the company does apply to both preferred and common stock. So this brings us to another major advantage. An investor can predict the movement of preferred stock because it always follows the common stock which instantaneously tracks investor sentiment based on current news. Having said that, an investor must be really careful not to place such an arbitrage trade close to earnings, court ruling, board elections or any other news expected by that investor. Always remember that it is not the news but the way the market perceives the news that moves stock price. Such a trade placed by a vigilant investor will ensure that the common stock maintains the direction of its movement which the investor was tracking till the trade has been placed.
I am sure what the discussion above will open you eyes to a whole new area of investment strategy. Hold on now…before you place a bunch of money in preferred stock which lags commons stock be sure to try this strategy out with small or no money by tracking such shares.
Case Study 1
The above column is focused on an arbitrage where we are assuming that the price of preferred stock will converge with the price of common stock.
But in the following case study, investors are betting that there is too large of a spread between the common and preferred stock. The article suggests not only to buy preferred stock but to sell common stock as the author believes that the stock prices will converge some where in between the current spread.
http://www.bloomberg.com/apps/news?pid=20601086&sid=aAdZKSyBdqjs
Case Study 2
But in the following case study, investors are betting that there is too large of a spread between the common and preferred stock. The article suggests not only to buy preferred stock but to sell common stock as the author believes that the stock prices will converge some where in between the current spread.
http://www.bloomberg.com/apps/news?pid=20601086&sid=aAdZKSyBdqjs
Case Study 2
All the above strategies I have mentioned are good for a healthy company. But in case you want to analyze how certain news about a distressed company can lead to different arbitrage trade, please read the following article.
http://www.marketwatch.com/story/investors-buy-citi-preferred-sell-common
Until then…its Suaz signing off…
http://www.marketwatch.com/story/investors-buy-citi-preferred-sell-common
Until then…its Suaz signing off…
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