I just started reading Inefficient Markets: An Introduction to Behavior Finance by Andrei Shleifer where he pretty much dispatches the notion that markets are efficient, as envisioned by the great minds who postulated the Efficient Market Hypothesis (EMH). One argument that EMH uses to promote this notion of efficient markets is that arbitrageurs will clean up irrational trading inefficiencies (known as noise trading) through a process of selling an 'over-valued' security while simultaneously buying the same (or nearly the same) 'under-valued' security. Well, I thought Apple's introduction of a new gizmo would be a good time to try my hand at arbitrage, so I quickly funded my paper money account with $100,000 and set up the trade three hours before Steve Jobs took the stage.
I needed to think about this for a while at first. Would you short Apple and go long a similar security or would you set it up the other way around? My reasoning was that Apple's price already included the news, so once the news became public, the price would tumble back a bit (sell the news logic). So I set up a nominally equal pair trade that had 100 shares short Apple ($205.78) and 460 shares long QQQQ ($44.46), which is the Nasdaq 100 of which Apple is a proud participant. After the Jobs presentation, Apple didn't do much, so I waited it out for another day. Hey, why not. It's not real money. And you're not supposed to lose at arbitrage anyway.
The next day is when this trade would have paid off. Apple tumbled and was trading at $192.12 near the close (net profit of $1,366) while the QQQQ fell to only $42.80 (net loss of $763.60). Our fictitious arbitrageur made a net profit of about $600 for what amounts to $20,000 margin for a retail account (presumably arbitrageurs have better leverage). Not bad for a couple days work that doesn't require any technical analysis.
So chalk one up for EMH. Noise traders pumped up Apple's stock before the Steve Jobs presentation, and our fictitious arbitrageur cashed in. But what happens if the noise trader would've gotten noisier? The trade could have gotten worse before it reverted, and at what point does an arbitrage go bust? And was this reversion a product of market forces or does it have an element of luck? One trade does not a system make. At the very least, it's interesting to observe this phenomenon.
3 comments:
he he... Ask LTCM at which point an arbitrage goes bust :)) Or Vic Niederhoffer...
But you probably already know I am a trend follower that believes that "inefficiencies" can last longer than people think (market wrong, you solvent and all that :)
Well done on the 3% return on margin in a couple of days (shame it was paper money).
Quite seduced by the iPad though (as an extra "gadget" potentially replacing/cross between iPhone and Kindle)
My personal take on the iPad - you can have it. I like my Kindle. It delivers on its goal of providing a platform for the reader to get lost in reading, versus waiting to become stimulated with flash and circumstance. That being said, I of course hope for the success of the iPad as I'm sure it will spur some interesting development in technology.
Can I just point out, that is not an arbitrage trade. An arb is trading in two securities that are identically, or virtually identical, to profit from there being a mispricing between them. What you traded was akin to a mean reversion (which LTCM traded a lot of), where you believe that the spread between two instruments is either too wide or too narrow, and you trade to profit from the 'reversion to the mean' of that spread.
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