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How arbitrageurs profit from short selling

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Everyone can come up with a reason to short a stock, but then there are the arbitrageurs.

Known on Wall Street simply as “arbs,” arbitrageurs are market participants using “statistical- arbitrage trades,” which is a different approach to betting against a stock than taken by the traditional short seller. That said, let’s take a look at how arbs attempt to profit from selling short.

Basics of statistical arbitrage

Arbs attempt to profit from changing temporary inefficiencies in the market. More specifically, statistical arbitrageurs implement paired trading strategies in an attempt to profit from the inefficiencies between the price spreads of similar securities.

The whole idea behind pairs trading is to use statistical techniques that indicate an inefficiency in the prices of two securities that should be trading in tandem.Once the price spread deviates, statistical arbitrageurs will get long one security and short a similar security. They’re looking for the price of the security that they shorted to fall, and the price of the security they’re long to rise. Ultimately these prices should fall and rise to a point at which the inefficiency dries up, at which point they take their profits and exit both positions.

Here’s an example of a pairs trade that statistical arbitrageurs might make.

Alphabet Inc Class A (GOOGL) and Class C (GOOG) theoretically should move in lock-step; the primary difference between the two is that GOOGL shares carry voting rights while GOOG doesn’t; as a result, GOOGL should trade at a premium to GOOG.

Check out the 15-minute chart of GOOG and GOOGL to see how arbs could profit from short selling.

The line plot is of GOOGL, while the candlestick plot is GOOG. Notice how GOOGL was trading below GOOG at one point; at that point, an arbitrageur would short GOOG and buy GOOGL, in an attempt to profit from the price discrepancy. Now the inefficiency eventually evaporated, and the arbitrageur would have profited from the short position in GOOG.

The bottom line

Arbitrageurs simultaneously enter into long and short positions to potentially profit from temporary price discrepancies. Their short positions are highly targeted and typically short-term in nature, done for different reasons than the ordinary trader looking to profit from a stock’s decline.

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   Petra Hess runs PetraPicks.com. She is a technical swing trader and long-term investor in domestic and Canadian stocks and ETFs.

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