Explain it to me like I am a 5-year-old: Basic Trading Strategies Every Investor Should Be Aware Of

I am a graduate student pursuing Masters in Computer Science from NYU wanting to understand finance and many of the underlying concepts. This post is meant for people who are completely new to Finance but want to have a basic understanding of the stock market. My aim here is to make the concepts easier and more understandable.

Arbitrage:

Let’s say you are a salesperson who wants to sell earphones but you are not aware of the price range for your area so you go to a market near your house and find the price of 1 set of earphones to be $10. Now you go to another market, a little far from your house and see that the price of 1 set of the same earphones is $15.

Why is there a difference in the price of the same set of earphones in two different markets? Because of different people with different backgrounds and different thinking buying from different markets which in financial terms is called market inefficiency. How do you make a profit from it? You buy earphones from the market where it is being sold at $10 and sell it for $15 in the market where it's worth $15. Thus you make a profit of $5/set of earphones. This is what we call as arbitrage. It is the profit that we get from the price differences of identical financial instruments on different markets or different forms.

Arbitrage takes place when security is bought in one market and is sold in another market at a higher price which is basically risk-free trading. But nowadays because of computerized trading, these arbitrage opportunities are easily detected by computers and are vanished in seconds. There are two main types of arbitrage: Pure and Risk.

Pure Arbitrage is a risk-free arbitrage. Let’s say a stock of company X is being sold at Bombay Stock Exchange for $50 while the same company’s stock is being sold at New York Stock Exchange for $50.50. Here the trader can buy the stocks from Bombay Stock Exchange for $50 and sell it at the New York Stock Exchange for $50.50 making a profit of 50 cents. This is an example of Pure Arbitrage which is risk-free as you are confident about making a profit.

Risk Arbitrage is speculative meaning it depends on future events which may or may not happen hence it involves risk. Let’s say a Dena Bank’s stock sells for $10 while Bank of Baroda’s stock sells for $15. If you think that there is going to be a merger between Bank of Baroda and Dena Bank then you can buy 100 stocks of Dena Bank for $1000 (10 x 100) and once it merges with Bank of Baroda, you can sell the 100 shares for $1500 (15 x 100). As you can see, here the profits depend on the merging of the two banks. If they don’t merge then there might be a loss hence it is called a Risk Arbitrage.

Hedging:

To know about what hedging is and how to use them, have a look at my Medium Post.

Please do let me know if there is any other concept in finance you want me to write an article on, I will try my best to explain it in simpler terms.

Also, feel free to ask questions in the comment section. Will be happy to help you out :)

PS: The analogy I have used might not be 100% correct but it’s easy to understand things with a simpler analogy.

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