The Magic of Arbitrage

A most tragic event occurred in Naperville, Illinois, on June 12. A young man, only 20 years of age, took his own life when the experimental investment program he engaged in – the trading in stock options – caused him to believe he lost nearly three-quarters of a million dollars on a single transaction, thereby dooming him to poverty for the rest of his life.

It may seem strange that persons so young become embroiled in complex investment schemes, but the harvesting of the millennial generation by aggressive brokerage firms is now the latest twist in acquiring clients. Established firms as prominent as TD Ameritrade, Merrill Lynch and Charles Schwab currently embrace commission-free trading and zero-minimum balances in an effort to attract the youngest possible customers, most of whom possess little or no understanding of what they are dabbling in.

And to sensationalize the experience, normally conducted online, the brokerages will display such contrivances as confetti displays and champagne corks popping after each trade. It’s clear they seek to gamify trading and couch it as an investment.

In the prior paragraphs I used a term which deserves to be more closely examined: “complex investment schemes.” These are not designed merely to bamboozle inexperienced youngsters. They’re, instead, what constitute the vast majority of the investments marketed to the investing public of all ages and income levels.

These artifices are woven into each offering in a manner to dissuade investors from knowledgeably participating in the oversight of their investments … this in keeping with a line by the English poet Thomas Gray, from his 1742 “Ode on a Distant Prospect of Eaton College.” “Where ignorance is bliss, ‘tis folly to be wise.”

And with this, I’ll now enlighten you on what I believe to be the finest approach to investment you can make. The method is known as arbitrage, with its dictionary definition as: “the nearly simultaneous purchase and sale of securities and foreign exchange in different markets in order to profit from price discrepancies.” However, I expand the definition to include a far greater variety of items and markets.

Let me give you the simplest example I can quickly come up with, the operation of a bank. In the olden days its principal function consisted of accepting money from depositors while loaning to borrowers. As customarily done at the time, the bank paid 3% interest on the deposits and collected 6% interest from borrowers. The simultaneous 3% differential constituted their profit. This, in my opinion, is the soundest approach to investment you can engage in. Mind you, however, a profit is not guaranteed – nor may it ever be – for if your borrowers fail to make their payments to you, your project will go awry.

I’ll now give you a variation to our banking example. It’s a machination known in the real estate business as a double escrow. Although I’ll admit to rarely having the opportunity to accomplish this feat, it’s pulled off every so often. It consists, very simply, of contracting to purchase a property at a particular price, and while in escrow, entering into an agreement for its sale with another party, in a separate escrow, at an enhanced price.

If the two transactions then close escrow simultaneously … or at least on the same date … you’ve essentially accomplished a double escrow. The benefit is obvious; you derive a profit with no requirement for you to effectively expend any funds whatever to facilitate the transaction. For those of you who enjoy expressing your profit as an annual percentage rate (APR), double escrows calculate out to an APR of infinity (). it’s not mathematically possible to do better.

For those persons in the securities field, who rely upon arbitrage to provide a livelihood, it’s not a stroll in the park. In many instances the uncertainties of an unpredictable market cause enough impediments to frustrate the most resilient among us. It takes a truly talented individual, with remarkable expertise, to consistently prosper in the arbitrage business. With this said, I’d like to relate the tale of a young man who accurately identified a security which offered just such an opportunity and attempted to capitalize on it in the hope it would propel him to riches.

We must go back a full century to the year 1920, with America in the process of recovering – emotionally and economically – from its involvement in the First World War. You might note that in 1906, just eight years prior to the commencement of hostilities, the International Reply Coupon (IRC) … more popularly referred to as a postal reply coupon … was introduced at a Universal Postal Union (UPU) congress in Rome. At the time an IRC was exchangeable for a single-rate, ordinary postage stamp for delivery to a foreign nation at the minimum postage for such a letter.

Apparently with no prompting, our eager 38-year-old entrepreneur conceived of the idea that profit could be made by taking advantage of the differing postal rates in various countries to purchase IRCs cheaply in one country and exchange them for stamps of a higher value in another country. In theory the concept qualified as an example of arbitrage at its finest.

Unfortunately, theory and practicality often reside in different hemispheres. In practice, the logistical problems proved to be insurmountable. The overhead on buying and selling large numbers of very low-value IRCs, together with ongoing fluctuations in currency value and exchange rates, precluded any profitability.

Although the project truly started in good faith, you’ll know how it ended when informed of the name of our aspirant. He was Carlo Ponzi, far more famously known as Charles Ponzi, a criminal with a cunning mind and impressive verbal skills. His name is permanently associated with a type of investment fraud wherein lucrative returns are promised and early investors compensated with money raised from subsequent ones. He’ll be forever remembered by the phrase which bears his name: “The Ponzi Scheme.”

In case you’ve not quite recognized where this article is going, it’s time I spell it out. Its title, proclaiming arbitrage to be magic, is unfortunately prophetic. If you hope to craft an investment program in which you must consistently identify securities that can be simultaneous purchased and sold at prices to yield a net profit, the likelihood is you’ll not be successful. Despite this reality, there are countless promoters who will promise you it can be done under their guidance. As I’ve suggested before, you dare not place your confidence in advisors who encourage repetitive buy and sell activity.

My years of involvement in stocks and bonds convinced me the soundest approach to the corporate market is investment in common stocks of well-established firms on the New York Stock Exchange. I selected companies in healthy industries with a history of stable or increasing earnings, a generous portion regularly passed on as dividends. I preferred only companies with reasonably low price-earnings (P-E) ratios and reviewed the portfolio every several months so to dispose of those no longer meeting the criteria. And as for specific cautions, I’ll pass on the following.

1) Do not, under any circumstances, authorize a brokerage establishment or individual stockbroker to maintain a discretionary account. Only you may make such decisions.

2) Do not trade in put and call options. They contain an element of risk you don’t need. Only the seasoned speculator belongs anywhere in the vicinity.

3) What is true for options is doubly so for the commodities market.

4) Unless it’s your personal specialty, avoid the precious metals market.

A final thought: Welcome to the world of modern technology. It has enabled the scammers, who were once forced to fleece their marks slowly and precariously, to now enrapture them with all the verve the 21st Century can bring to bear.

Al Jacobs, a professional investor for nearly a half-century, issues weekly financial articles in which he shares his financial knowledge and experience. Al can be contacted at al@abjacobs.com