There’s a trading method that professional fund managers and institutional traders have been using for years – yet until the introduction of Contracts for Difference (CFDs) into the Australian market, it was a strategy almost impossible for retail investors to trade profitably.
The technical term is arbitrage. The theory is simple. It means trading the same financial instrument in two different markets to take advantage of price discrepancies between the two.
But I should make one thing clear. This isn’t a true risk-free arbitrage trade. But it’s probably the closest retail investors can get to it.
You see, between Australian, UK and US markets there are tens of stocks that have listings on multiple exchanges. The key to making the trade work effectively is for the dual listed stocks to have enough liquidity in both markets. If the spread between the bid and offer is too wide it makes it harder to maximise returns.
So, to find out how it all works with CFDs and which stocks offer the best potential for this trade I spoke to Anthony Anderson.
According to Anderson traders have been flooding into Rio Tinto for this strategy because it’s been trading stronger in the London market than locally. This has involved clients shorting Rio on the close after a strong London rally then covering it on the open during Sydney trading.
On several occasions Rio was up by 10% in London but only between 3 to 5% here the following day.
And it’s not just Rio that offers the opportunity for the trade. There are others such as BHP Billiton, News Ltd, Aquarius Platinum, Lihir, and Resmed.
In fact, MF Global’s institutional desk has dealers whose main role is to trade for clients on these price differences. Perhaps not surprisingly, two of the most popular trades have been on the Australian and UK listings of Rio Tinto and BHP Billiton.
Here’s how a trade in BHP Billiton might work:
You are currently long 1,000 CFDs of Australian listed BHP Billiton Ltd at a closing price of $30.00. The total value of your holding is $30,000.
When the London market opens at 5pm our time you notice the UK listed BHP Billiton shares rally strongly from 1400p to 1500p. Despite this you believe the advance in the share price won’t last through until the Australian market opens the following morning.
So, to take advantage of the London price movement you place the following trade to short sell 1,000 CFDs of the UK listed BHP Billiton Plc at 1500p, for a total value of GBP15,000.
By the next morning when the Australian market opens you have the following position:
Long 1,000 BHP Billiton Ltd CFDs valued at $30,000
Short 1,000 BHP Billiton Plc CFDs valued at GBP15,000
As the Australian market opens you notice your prediction was right. Trading in BHP Billiton shares is sluggish and the price rise is only modest. You choose to wait until the close and sell your Australian listed BHP Billiton Ltd CFDs at $30.50 for a total sum of $30,500 and a gross profit of $500.
An hour later the London market opens and following the lacklustre day of trading in Australia, BHP Billiton Plc CFDs begin trading lower at just 1470p as the market gives back some of the previous days gains.
You close out this position for a profit of 1,000 x 30p = GBP300 ($625).
That gives you a gross profit on the trades of $500 + $625 = $1,125.
Here’s a summary of the trades…
BHP Billiton Ltd
1,000 @ $30.00
BHP Billiton Plc
1,000 @ GBP 1,500p
BHP Billiton Ltd
1,000 @ $30.50
BHP Billiton Plc
1,000 @ GBP 1,470p
GBP 300 ($625)
Total Gross Profit
This example shows how to take advantage of price movements overseas to make profits on positions you hold here.
Because it isn’t a completely risk-free trade it would have been possible to make a loss. That would happen if the Australian CFDs had fallen while the UK CFDs had risen. In that case you would have lost on both sides of the trade.
But that’s just part of the calculated risks you take as a trader. In reality price discrepancies shouldn’t last long in these markets, as the big institutions are able to take advantage of the price difference and close the gap.
The alternative strategy is to just trade the Australian listed CFDs which would have returned a profit of just $500.
By using this ‘arbitrage’ strategy your trading result more than doubles.
But remember, it is a trade with a higher level of complexity than a standard buy and sell trade. So it isn’t for everyone.