Three Strategies Every Short Seller Must Know

3. The Arbitrage Short

Arbitrage transactions are the simultaneous purchase of one (or more) securities and the short selling of one (or more) other securities, which may or not be related to each other. Some common arbitrage transactions are:

• Index Arbitrage: This is the off-setting of a "basket" of stocks vs. a derivative , such as index options , futures or swaps .
• Convertible Arbitrage: Typically achieved by buying a convertible bond or preferred stock and then short selling common stock or options (on a delta basis) against the convertible securities.
• Risk Arbitrage: Risk arbitrage opportunities exist when one company has agreed to or is in the process of trying to acquire another company. Since the deal has yet to be consummated, there will be a risk that the deal will fail, thus creating a discount to the price of the target shares . In that situation, the arbitrageur will buy the target company and short sell the acquiring company. For example, Toronto-Dominion Bank (TD) has recently agreed to purchase Commerce Bancorp (CBH) for 0.4142 TD shares plus $10.50 for each CBH share. The arbitrage here would be to buy CBH and short sell 0.4142 TD for each CBH share.
• Pairs Trading: When the relative values or technical nature of two stocks have diverged this may create a trading opportunity. Some traders will refer to this as "mean reversion trading." What follows is an example of pairs trading. Below is a two-year chart of Abercrombie & Fitch (ANF) (in blue) vs. American Eagle Outfitters (AEO) (in red). The assumption is that the two stocks are closely related in terms of fundamentals and business models, so they should perform relatively in synch with each other. However, as we see in August 2006, ANF was cheap relative to AEO. At that time, an investor would probably buy ANF and short sell AEO in anticipation of ANF rising relative to AEO over time. And that is indeed what happened over the course of the next year until finally, the spread between the two stocks' performance collapsed by August 2007.
  
• Short Against the Box: This was a frequently used strategy that took advantage of an old "loophole" in the tax code that has since closed. Under the old tax code, if you owned a low cost-basis stock, you could sell the same company's stock but instead of selling your long stock you set up a separate short sale. This created a separate long and short in your account , thus avoiding the realization of a capital gain . You can still use the "short against the box" strategy for short periods of time so long as you comply with the related Internal Revenue Service (IRS) regulations. As an alternative, many investors now create a pair arbitrage to attempt to replicate a short against the box. However, the pair is not as precise in off-setting risk as is the short against the box.

While it may seem that we are finished discussing short selling, there is one final lesson to be learned. Next time, I will cover the risks of short selling. Until then, here is some homework:

1. Look for a fundamental short opportunity, based on your analysis of a company.

2. Look ahead to a data-related event and strategize how you would position yourself leading up to the event and how you would trade after the event has occurred.

3. Try to create a pairs trade like the one I highlighted above.

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