Advent of Alpha Day 4: Derivative Arbitrage

Yes, this idea of daily posts hasn’t worked quite as well as I had hoped. A mixture of illness, travel, work and other stuff meant I’m rather behind. But let’s crack on.

Due to time pressures, these articles are going to get a little more “bite-sized”, but if something grabs you and you want to discuss it, there will be threads on the betcode slack.

“Derivative Arbitrage” is not a technical term I’ve ever heard anybody ever use, I just don’t know a better one when trying to describe it in a two word phrase. The core idea here is that prices in one market can help you price another.

The simplest example is a win market providing an indication of how a place market or each way market should be priced.

Whenever this comes up, everybody mentions Harville (1973). This paper got enough attention that a micro-industry[1] seems to have popped up in other papers pointing out that his formula overestimates the probability of a favourite finishing second or third.

However when digging around for ideas in this space I found a nice paper by Bjerksund and Stensland (2017). I’ll just leave the abstract here to get you excited about:

“We have collected odds and results from 7 474 horse races in Norway and Sweden for a period of approximately 1.5 years. Based on the odds from the win game, we construct a profitable betting strategy for the corresponding triple game. Given a 30% track take, the existence of a profitable strategy is surprising. A robot is typically needed to identify and exploit underrated bets. We argue that the existence of heterogeneous beliefs between players in the market might form a basis for profitable betting strategies. We did expect that bigger pools (more liquidity) would remove this anomaly. That is not the case. More players, and thereby bigger pools, increases the profitability of the system.”

The ideas and methods aren’t new. The “Dr. Z System” has sold plenty of copies and has stood the test of time, and is based on the same ideas and concepts. To me it is interesting people are still finding angles with it.

I’ll also point you in the direction of thinking about prop bets and how they are derivatives of “core” markets: if Man City are priced at X to lead at half time, what does that mean in terms of pricing Harland to be first goal scorer, and the like?

A vein of thought to consider, perhaps.

[1] Stern (1980), Henery (1991), Lo et al. (1995)