Advent of Alpha Day 3: Basic Arbitrage

Arbitrage (or “arbing”), in a basic form the simultaneous (or near simulataneous) buying and selling of the same or equivalent assets in different markets in such a way as to guarantee a profit. Buy low, sell high, just like market making, but you’re doing it in two places at the exact same time.

If a friend is offering to sell you his old games console for £100, and you know somebody who has been looking for that exact same console with a budget of £150 in mind, you have the ability to arb it, lock in £50 and make both your friends happy. This is boring stuff, but it’s simple and useful.

Whenever I started talking about arbing years ago to people who didn’t bet, they looked at me wild eyed. The more fiscally astute might mention “the efficient market hypothesis”, when I pointed out that people were manually finding price discrepanciens between bookmakers.

I’m going to come back to EMH another time, but short version: I don’t believe in the version of the hypothesis that says all markets must be efficient all of the time. If that were true, the City of London would not exist in its current form. Wall Street would be dead. Nobody would ever take a price on an exchange and matched volume would die. Bookmakers would not have a business model.

It’s just bollocks.

Many years ago, one friend (who wasn’t very betting literate), suggested to me that there might be something in betting with UK bookmakers and Australian bookmakers on either side of an Ashes cricket match because they’d have to adjust prices to local biases - even I found myself mentioning EMH at this point.

But there is a germ of an idea in there somewhere. This is “pennies in front of a steamroller” territory, but if you don’t look for ideas in arbing, you’ll never find them.

A Basic Worked Example

Let’s imagine Australian and British bookmakers have never heard of each other and the Ashes cricket match example is real. The Weight of Money (WOM) each sees mean that patriotic punters on either side of the globe results in an absurd and unrealistic situation:

1. The Australians price their side to win at 1.6 and England to win at 2.1. You can use these numbers as divisors of 100 to work out the percentages (62.5% and 47.6% respectively), suggesting the bastards are offering ~110% over-round on a 2-runner market.
2. The English bookmakers have been similarily pummelled and their prices are inverted - England are at 1.6 and Australia are 2.1

The arb here is obvious. You’re going to back Australia in England, and England in Austrlia. You’ll make 10% on what you’re able to get on. Lovely.

Of course, even Australiani bookmakers have basic communication systems like steam boat mail these days, and English bookmakers have been known to use technologies at least as sophisticated as Teletext to discover prices, so the enterprising sharps on boths sides of the planet will do exactly this: the Austrialian bookies will lay the locals 1.6, and then back them with their English counterparts at 2.1, and vice versa. Overtime the prices inch closer to each other (known as “price discovery”), and eventually the markets will look identical the World over. Well, until a syndicate in Macau bribes one of the captains, and then it gets more complicated…

The trick to arbitrage then is finding pricing discrepancies before the price discovery is made. This is potentially profitable, and you can also tell your Mum you’re helping markets become more efficient, while really you’re just trying to find an excuse to watch sport all day.

On-course Bookmakers

I think it’s widely known that on-course bookmakers on UK racecourses are “laying off” into exchanges. If you find yourself at a racecourse of an afternoon and after a couple of pints of £8 Guinness can’t operate the (frankly, not very good), exchange app on your phone anymore, you’ll have a bet a glum looking man in Tattersall’s (they all look glum). You might wonder what’s going on behind the board with the clerk on the laptop.

The software they’re using started life as an electronic version of the clerk’s book (I could write a whole article on that one day - it’s how I reconcile my own positions on a lot of strategies), but these days it is typically connected to an exchange - Betdaq is the most popular, I hear - and immediately laying off into the exchange. If the price on the exchange move, the bookmakers’ boards move, while taking into account their own positions.

This system might sound new and modern, but in fact it is just an update of what always used to happen in the ring. People who understood a strange sign language called tic tac would stand at one end of the enclosure, signal what prices they could see, and more often than not, take instructions to have a bet with a bookmaker over there when instructed by their manager back at his own board. At “first show” on a race, most bookmakers started with the same prices compiled for them (the “tissue”, named for the very thin paper it was produced on by the compilers selling them prices before everyone just used Racing Post prices), but occasionally there would be discrepancies - perhaps they’d taken a big position that morning they needed to lay off - and price discovery would swing into action, with satchels of cash moving around the ring.

Ladbrokes used to have people who did nothing but this. They’d take off course bets in their shops and then have people with literal wads of cash walk into the ring and arb the price to a place where their own liabilities on SP bets looked good (this was in the days when Industry SP was set in the on-course rings). Tic tacs even had a sign for Ladbrokes, from which that firm got the nick name - “Magic Circle”.

Now its all digital. Exchanges are where price discovery is really happening, and SP is set off course.

But how does any of that help you? Where’s your alpha?

Money flows

If you saw you could back a selection at 3.5 on one exchange, and lay it at 3.2 on another, would you? This is the same situation as your friends selling and buying a games console. You can lock in a profit.

As you take those prices (and note you should be taking, not making prices, here), the market moves in - 3.5 becomes 3.4 and elsewhere the 3.2 becomes 3.3. You go again. The market moves, and we’re now at 3.3 or 3.4 everywhere, or they cross and both settle on the same back/lay spread.

This is EMH in action. Basic arbitrage.

There are more subtle examples though - by looking across multiple markets and multiple selections and taking the highest prices available, you might spot an aggregate “over broke” book: the percentages add up to less than 100%, and you can therefore “dutch” them and lock in a profit.

With bookmaker over-rounds, this is most likely to occur on markets with a small number of win options, and where over-rounds can be tight anyway (football, cricket, tennis), but I would not be amazed to see it happening in those prop markets with a huge number of selections where the tissue is hard to calculate and likely proprietary as long as the over-rounds aren’t too mean.

I’ve never dived into this in a lot of detail, but I hope to next year - and document progress here - as I think it’s one of the simplest and most lucrative methods going.

What to Think About Next

Of course you won’t be alone in thinking about this opportunity, and most arbitrage opportunities involve being a bit more creative (the next articles cover some of this a little), but one thing you’re going to have to do is automate.

If anyone else is automating - and I do mean anyone else on Earth - across the markets you are looking at, then you need to automate as well. Long gone are the days of being able to take a look at an odds comparison site, realise that one bookmaker is out of line with everyone else and dive in with your debit card in hand.

Flumine last year took a step in being able to generalise into other exchanges and markets by adding support for BetConnect (which is a different beast to other exchange platforms), and there are other tools out there that would allow you to dip into other exchanges like Betdaq.

Oh, and two last things: don’t forget commission when doing your maths, and I strongly advise you only ever take prices - making them in arbs is a whole different strategy.