This is part II of the article: Arbitrage Trading: Example, Introduction, Overview-I. Please start with this first part before continuing with this one.
A simple way to beat the failure in arbitrage trading is to go for effective capital management and keep on doubling your bets if your buy decision goes wrong. However, there has been no sure shot model through which risk-free profit can be made. Ultimately, Arbitrage Trading is nothing but BETTING.
Computers have been used to directly trade using algorithms, using capital management concepts - yet till date - all these algorithms have resulted in big failures.
Take this case; Royal Dutch SHELL (a Holland based Oil company) is listed on both London stock exchange and Amsterdam stock exchange. As a part of my job, I was attempting to test if arbitrage opportunities exist between LSE and AEX.
There were some problems identified firsthand:
• London is one hour behind Amsterdam, so time difference factor had to be considered for pre market, post market and overlapping market timings.
• LSE trades in Pounds, while AEX trades in Euros, hence tick by tick data for forex should also be taken into consideration
Ultimately, after a long running effort, the algorithm was designed, tested and the back-testing showed that it is resulting in very very profitable results.
All set to go, the model was installed with live data feed and we were hoping that the computer will make billions for us, but within 3 hours it wiped off all our capital. Another few weeks we continued modifying the algorithm and testing with live feed from stock markets – it was profitable sometimes; and equally bad, it was in loss same no. of times.
What was hurting the model was the transaction costs. Unfortunately, we could not generate any realizable profitable gains – contrary to the success on historical data, the model was just not able to understand the market scenario. We kept on testing it over a long period of time, ultimately, it was sent to the “Recycle Bin”.
There has been no model in the history of stock markets which has managed to give a consistent and good Risk free return. That was the reason I’d questioned the Quant based “Lotus India Agile Fund” in my review.
The case of ETF is an interesting one. One of the readers had asked “If ETFs are the best bet in the market, why should anyone sell it?”. The reason is “Arbitrage Trading”.
The organizations which issue ETF’s buy the underlying stocks listed in the indices – that too in big number. Hence, they have a net positive position in terms of stocks. To offload that, they issue (or sell) ETF units, at a slightly higher price. Hence, their position is secure, because they do not have any net position, and yet they make decent profits. Ultimately, they have to keep an eye on Index changes, and consolidate their positions accordingly.
Can we individuals benefit from arbitrage trading?
YES – if you take up a fulltime traders job, and keep a constant eye on every single price change in the market hours. At the same time, you should also have big amount of money to play around with and ability to get wiped off completely. And yes, the LUCK factor – because MARKETS ARE EFFICIENT and RANDOMNESS RULES.
One may try his luck if he wishes
12 comments:
Thanks a lot Shobhit,
As always, another informative article - simple, clear and priceless
Had a question - how many countries in the world have more than one stock exchanges and common stock listings?
I realize you have nothing personally to do with the ads the blog-wallahs put up on your page, but can you talk to them to get rid of the blatantly tasteless one?
There's one, for example, which shimmies and shakes and tells you you are 999,999th visitor to get in, and urges you to click the link to "claim your reward". It's all humbug of the most blantant variety, of course, because I continue to remain the "999,999th" visitor through the last week.
It's downright insulting to have people shake such stupid ads under your nose. I mean, these guys (a) are dishonest; (b) want to fleece you; (c) think you're dumber than dumb; and (d) are so **&#$ blatant about it!
I repeat, I know you have nothing to do with this personally; but just like if the lane leading to your house is littered with excement and refuse, you'll probably move the authorities to get rid of it, could you do the same here?
Regards,
Yours,
Thoroughly Disgusted.
Sorry, Anonymous#1, and sorry, Shobhit, but that piece, although certainly informative and interesting, is FULL of holes (if you don't mind my pointing that out). It is simple, yes, but not particularly clear.
You're saying the Lotus quant fund doesn't work, and that quant funds in general can't work, because that one fund you personally worked on did not work. Shobhit, does that really make sense? Sorry to put this bluntly, but you and your organization may simply have been incompetent (or, to put it more politely, not good enough).
I'm not saying that the Lotus quant fund is good. I have no idea at all. But unless you've empirically tested their algorithm, there is one and only one position you can logically and without prejudice take on that issue, that of an agnostic.
No offence meant. I still think your blog is a great effort. Which is why I visit it regularly.
Cheers!
Siddhartha.
Thanks a lot Siddhartha for your honest comments!
I appreciate critical feedback!
Now coming to What works and what does not -
The blog I started is aimed at telling readers somethings which are not usually visible or we tend to ignore or take for granted.
It's easy to spot something as interesting and efficeint, the moment a "computer algorithm" is attached to it - However, it may not be true always. That was the reason I quoted the example of horoscope macthing by computers.
I have been honest in all my blogposts, and mainly I've quoted my failures.
Whatever knowledge I've gained during my finance studies and my career, with that I'm quoting the examples and facts. If you can quote a single fund manager who has beaten the stock market consistently for even 3-4 long years, I will be happy to give away all my ETF investmetns to him. Whether he was using a computer or not, it does not matter. No fund manager has outperformed the ETFs consistently.
If you can quote a single algorithm or model which has worked consistently making profits ever after, I will be very happy to delete my blog article.
If you've heard of the best selling book "When Genius failed" - then you would realize the costly assumptions of algorthmic investments. The fund was managed based on an algorithm, and was managed non other then by a "Nobel Prize Winner" and it failed miserably, setting examples for dependency on computers. The nobel lauret faced a widespread criticsm. You can read the review of the book at amzon.com
I attempt to publish facts and historical failures. I never said that one should not invest in Lotus india fund. Instead, I ended the article by saying" Investors can try thier luck". The fact is that things work randomly, no computer or algorithm can get anything out of anyone.
Siddhartha,
This is Vijay (Anonymous#1)
I think you are not getting the main point of this blog.
This blog convinces me that things work randomly and so no body or any computer can predict anything.
That's all I can say.
I think shobhit has already given you a convincing reply.
-Vijay
Hate to be argumentative, Shobhit and Vijay, but this is precisely the point I was trying to make. I agree with all you've said up there, but just look at Vijay's comments above. He appears convinced that "things work randomly and so no body or any computer can predict anything". No skin off MY nose, but I think we'll both doing him a disservice if we don't point out to him that, while we need to be on our guard and so on, but to say that nothing can beat the market (while possibly true) will be taking an unwarranted logical leap. Example? Take Warren Buffet! (Although Shobhit, please DON'T delete your blog, I love reading it, and this is just a friendly discussion.)
Anyway, so much more round-and-round arguments.
I'd welcome your view, Shobhit, on one point I'd raised earlier. What you're advocating, that we all invest in mutual funds... it may (or may not, I'm not arguing that now) be best for you and me and a few others, but if everyone started doing it, what would happen? After all, indices move BECASUE STOCKS MOVE.
Comments?
My answer would be: don't buy portfolios, don't buy index funds, don't buy "investments" -- buy businesses. Look at companies that you think are solid, and then invest in them for the long-term. As in Reliance. As in Infosys. As in Microsoft.
And how do identify them before they've become big? That's where research comes in. That's where your judgement comes in. That's what sets apart a good investor from a mediocre one. That's what sets apart a Warrent Buffet.
Siddhartha.
sorry, i meant "we all invest in INDEX funds" (in my comments above) -- not in "mutual" funds.
S.
Siddhartha,
I too have done my MBA and learnt a bit about finance. That is the reason I agree with Shobhit and his blog concepts.
"Dont buy Investments, Buy Businesses" is a well known idea of Warren Buffet. Nothing new or great in it. As Shobhit has rightly mentioned in one of his posts, that why is there only 1 warren buffet in the world, if everyne knows all the investments and business concpets of him.
ANother thing- Warren Buffet is NOT an investor - he is a private equity player kind. THere is a huge difference between an investor and private equity player.
Shobhit - No need to delete your blog - your concepts are absolutely correct.
Regards
Vijay
Hi All,
As suggested, here is the link to the "LTCM book - When Genius Failed" review on amazon.com
http://www.amazon.com/When-Genius-Failed-Long-Term-Management/dp/0375758259/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1197015701&sr=1-1
First read the editorial review, then read the customer review...
See how the Nobel prize winner failed with his model.
Want to arm-wrestle, Vijay, to settle the issue?
You've done your MBA, Vijay, and so have I, but we're both either very successful or total failures. That's why we both have so much time on our hands! ;-)
Vishal, thanks for the link.
Shobhit, I know it's getting dawn, and about time your guests vacated your party and left you alone.\
Cheers!
Siddhartha.
Hi Siddartha,
I'm not here to arm-wrestle with anyone.
Working since last 8 years and having done my MBA from IIM-Cal, just to gain some limited knowledge about finance.
Not sure what your intentions are...but I've been reading all the blogposts of Shobhit silently till now. With the limited knowledge that I could garner from IIM-cal and from practical work and from blogs like that of shobhit, I am convinced about randomness in financial world. I have also observed the type of questions and objections you have posted to all previous articles of Shobhit (Including the Halle Barry, James Bond reply)
I appreciate that you are also an MBA grad - definitely from a reputed institute (as I can observe from your style of replies and ques), so no point in trying to tell you anything.
Also, this is a beautiful piece of work by shobhit, I dont want to create a mess here on this blog trying to justify my point and support shobhit - ultimately ending up dirtying this blog.
Sorry, will not be able to reply to any of your comments further.
Shobhit - Sorry for this non-sense on your blog. But I follow your blog religiously. Keep it up, its a great piece of work.
-Vijay
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