Convergence Trading Strategies

Convergence trading strategies try to profit from the temporary mispricing of two related financial instruments that have diverged from their long-term equilibrium relationship. 

Traders establish positions that will ideally benefit when the identified mispricing corrects itself and the assets converge back toward their expected equilibrium. 

A deep understanding of the cause-effect mechanics and drivers of each market and strategy is very important, as well as a disciplined entry and exit approach to go along with strict risk management.

Temporarily divergent prices can persist for some time before the anticipated convergence occurs.

Key Takeaways – Convergence Trading Strategies

• Futures Basis Trade
• Fixed Income Convergence Trade
• Pre-Refunded Bond Arbitrage
• Merger Arbitrage
• Pairs Trading
• Calendar Spreads (Futures)
• Covered Interest Rate Parity (FX)
• Statistical Arbitrage
• Basket Trading
• ETF Arbitrage
• Regulation Arbitrage
• Dividend Arbitrage
• Triangular Arbitrage (FX)
• Volatility Dispersion Trading
• Commodity Spread Trading
• Inter-Market Spreading (Futures)
• Relative Value Option Trades
• Warrant Arbitrage
• Dual-Listed Company Arbitrage
• Synthetic Convertible Arbitrage
• Volatility Arbitrage
• Put-Call Parity Trades
• Index Arbitrage
• Convertible Bond Arbitrage

Futures Basis Trade

The basis trade is one of the most common convergence trades.

It involves taking advantage of the difference between the price of an underlying asset (e.g., a commodity like gold, oil, Treasury bonds, or wheat) and its corresponding futures contract.

If the futures contract is trading at a premium to the spot (current) price, a trader might buy the asset and simultaneously sell the futures contract.

The expectation is that the price differential will narrow as the futures contract approaches expiration.

Related: Element Capital Bond Auction Trading Strategy

Fixed Income Convergence Trade

This strategy focuses on mispricings within the fixed income market (bonds).

Traders look for bonds with similar characteristics (maturity, credit rating, etc.) that are priced differently.

They would buy the undervalued bond and short the overvalued bond, and expect their prices to match up over time.

Pre-Refunded Bond Arbitrage

Related to callable bonds, this strategy exploits the price differences between bonds that are “pre-refunded” (set aside for early redemption) and regular bonds.

Merger Arbitrage

Involves taking positions in companies involved in a merger or acquisition.

If the merger is expected to go through, a trader might buy shares of the company being acquired (which are often temporarily discounted in case the deal doesn’t close) and short shares of the acquiring company (as its shares may be temporarily inflated).

The goal is to profit from the prices converging as the merger closes.

Related: Special Situations Trading

Pairs Trading

A broader statistical arbitrage strategy, where a trader finds two historically correlated or cointegrated assets whose prices have diverged.

The trader goes long on the underperforming asset and short on the overperforming asset – i.e., betting on the correlation reasserting itself and the prices converging.

Calendar Spreads (Futures)

Similar to the basic futures basis trade, but focused on buying a futures contract with a near-term expiration and selling a contract with a longer-term expiration on the same underlying asset.

Or vice versa depending on the shape of the futures curve (backwardation or contango).

The trader anticipates the price difference between the contracts will narrow as time passes.

Covered Interest Rate Parity (FX)

This looks to take advantage of temporary deviations from the relationship between spot exchange rates, forward exchange rates, and interest rates between two countries.

Traders use multiple instruments (currency, bonds, forwards) to attempt to lock in a profit if there’s a misalignment.

Statistical Arbitrage (Stat Arb)

Statistical arbitrage is a broad category that includes various strategies that use statistical models to exploit pricing inefficiencies between related financial instruments.

Basket Trading

Instead of a single asset, this may involve discrepancies between a basket of related securities (like a sector ETF) and futures or options on that underlying basket.

It’s similar to index arbitrage but can be applied to more customized collections of assets.

It generally fits under the “stat arb” category.

Exchange-Traded Fund (ETF) Arbitrage

A subset of the basket trading, ETF arbitrage exploits price discrepancies between an ETF and its underlying assets by simultaneously buying the undervalued and selling the overvalued to lock in risk-free profits.

Regulation Arbitrage

This is more opportunistic as it seeks to exploit differences in pricing or regulations of the same asset across different markets or exchanges.

For example, a stock might trade at different prices on two global exchanges, or there might be temporary pricing differences between a stock and its corresponding ADR (American Depository Receipt).

Often requires a deeper understanding of multiple instruments, cross-market relationships, or even regulatory structures in different jurisdictions.

Dividend Arbitrage

Dividend arbitrage involves buying a stock before the ex-dividend date and hedging the position with put options to profit from the dividend payment while reducing price risk.

Related: Dividend Capture Trading Strategy

Triangular Arbitrage (FX)

Triangular arbitrage in the foreign exchange market involves executing three currency trades in a triangle to exploit discrepancies in exchange rates for a risk-free profit.

Example #1

Imagine you’re an FX trader monitoring the following three currencies:

• Dollar (USD)
• Euro (EUR), and
• British Pound (GBP)

Normally, these rates should indirectly connect (e.g., 1 USD = 0.8 EUR, 0.8 EUR = 0.7 GBP, so 1 USD should roughly equal 0.7 GBP).

Triangular arbitrage exploits situations where these indirect conversions are off.

Let’s say:

• 1 USD = 0.8 EUR (normal)
• 0.8 EUR buys you 0.72 GBP (GBP undervalued)
• 0.72 GBP buys you back ~1.03 USD (pocket the difference)

By quickly converting USD to EUR, then EUR to GBP (at the undervalued rate), and finally GBP back to USD (at the inflated rate), you pocket a profit despite going in a circle.

This is a simplified example, but it captures the essence of exploiting these temporary mispricing opportunities in the FX market.

Example #2

Many businesses are essentially arbitrage businesses.

Some businesses are as simple as buying in bulk and selling things individually.

Others have value-add on top of that (e.g., lemons, sugar, and water bought in bulk and turned into individual cups of lemonade).

For example, imagine you find a trendy phone case in China for $5 (in RMB equivalent) that sells for $20 in the US. 

• The all-in costs of getting the product to the US are $15 (the $5 plus costs).
• You list the Chinese phone case on your US store for $20.
• When a US customer buys it, you use their payment to buy the $15 US case and have it shipped directly to your customer.

This exploits the price difference between the US and Chinese products to pocket a profit.

For those who are advanced and want to avoid the impact of FX changes crimping their margins, they can construct futures trades to lock in their exchange rate.

Volatility Dispersion Trading

This strategy involves betting on the difference in implied volatility between an index and its constituent stocks, usually through options trading.

This would involve going long options on the index (e.g., long straddles, which is a pure vol bet) and shorting options on the individual stocks (e.g., short straddles).

Commodity Spread Trading

Commodity spread trading capitalizes on price differences between related commodities, such as buying one month’s futures contract and selling another’s to profit from the spread.

Inter-Market Spreading (Futures)

Inter-market spreading involves trading futures contracts in different markets (like commodities and currencies) to capitalize on price differences between related assets.

Related: Inter-Commodity Spreads Trading

Relative Value Option Trades

This strategy involves taking advantage of perceived discrepancies in the value between options based on the same underlying asset or related assets.

Warrant Arbitrage

Warrant arbitrage tries to exploit price differences between a company’s stock and its warrants – i.e., buying one and selling the other to secure a risk-free profit.

Dual-Listed Company Arbitrage

This strategy exploits price differences of the same company’s stock listed on multiple exchanges by buying the undervalued shares on one exchange and selling the overvalued shares on another.

Has also been used in crypto markets.

Synthetic Convertible Arbitrage

Synthetic convertible arbitrage involves using a combination of options and equities to mimic the characteristics of a convertible bond.

Example

Here’s a concise example of synthetic convertible arbitrage:

Imagine a company’s convertible bond lets you convert it into stock at $15/share. 

Instead of buying the bond, a synthetic convertible arbitrage trader might:

• Buy the company’s stock
• Sell a call option (right to buy the stock) with a strike price of $15, expiring around the same time as the bond.

This setup offers:

• Upside potential if the stock rises (like the bond)
• Some downside protection if the stock falls (also like the bond), but limited to the option’s premium
• Potential income from option premiums

Options-Based Convergence Strategies

Volatility Arbitrage

Seeks to exploit discrepancies between the implied volatility of an option and the realized volatility of the underlying asset.

If implied volatility (the market’s expectation of future price movement) is higher than the actual volatility, a trader might sell options (expecting them to decline in value) and buy the underlying asset to hedge.

Related: Barclays Options Trading Strategy

Put-Call Parity Trades

Leverages the theoretical relationship between puts and calls of the same strike price and expiration date on the same underlying asset.

If this relationship is violated, traders might buy the undervalued option and sell the overvalued option, expecting the prices to converge back to the parity relationship.

Flaws in Put-Call Parity

There are, however, many legitimate reasons why puts and calls of the same strike and expiration would be priced differently.

For example, in long-dated stock options, since the price of stocks is expected to go up over time, the calls will normally be higher than the puts.

There are, of course, always exceptions.

Cross-Asset Convergence

Index Arbitrage

Involves taking advantage of temporary differences in pricing between a stock index and its underlying components (the individual stocks within the index).

If the index is trading at a premium to the basket of its components, a trader might short the index and buy the constituents, expecting prices to converge.

Convertible Bond Arbitrage

Focuses on convertible bonds, securities that can be converted into a predetermined number of a company’s shares.

Traders look for situations where the convertible bond is undervalued relative to the underlying stock.

They might purchase the convertible bond and short the stock, expecting the bond price to increase as it converges with the stock’s value.

Important Factors in Convergence Trading

Mispricing

Successful convergence trading depends on accurately identifying temporary mispricings of related assets.

This often requires sophisticated analysis (it’s not easy to find a mispricing) and will take time setting up your process (code and data sources).

Start with One Strategy

Master one thing before moving on to another.

Convergence Timeline

It’s important to understand the cause-effect factors influencing price convergence and when it might occur.

In futures trades, you’ll need to time it before the contract expiry.

Risk

Convergence isn’t guaranteed.

If prices diverge further instead of converging, you might experience significant losses.

Most convergence strategies are run in interest rate and bond markets before they operate in more mathematical ways.

Stocks and currencies can be driven more by flows and “sentiment” and can stay undervalued or overvalued for longer periods of time.

Leverage

Many convergence trades use leverage to amplify returns as the initial profit margins can be slim.

Leverage also amplifies risk.

Before You Start

Convergence trading is typically more complex than traditional buy-and-hold styles of trading/investing.

You need:

Deep Market Understanding

Expertise in the specific asset class (commodities, fixed-income, equities) is #1.

Analytical Skills

You’ll need to identify price relationships, potential mispricings, and the factors that could influence convergence.

Risk Management

Due to the risks involved, it’s important to have strict risk management strategies, including, e.g., position sizing constraints, diversification, use of options.

Additional Considerations

Event-Driven

Corporate events like mergers, spin-offs, or dividend announcements can create temporary price dislocations.

This can potentially set up convergence trade opportunities.

High-Frequency Trading (HFT)

Some convergence and arbitrage trades, particularly those involving highly liquid and correlated assets, are identified and executed by sophisticated algorithmic HFT systems that are difficult for individual traders to replicate.

Opportunity May Be Fleeting

Mispricings that drive convergence trades can be corrected very quickly, especially in efficient markets.

Speed and accurate analysis are important.