Social Arbitrage Investing: A Beginner’s Guide

What is social arbitrage investing?

I’ve recently come across the concept of social arbitrage investing, so I thought a blog post on the topic could be really useful. Some people swear that it’s a great way to make money if you’re familiar with social media.

Social arbitrage investors rely on their knowledge and observations of what’s trending on social media and in the real world to decide what stocks they will buy. It’s said to be a way of investing when you know nothing about company finances but you’re good at spotting popular trends.

If that sounds like you, then you may be able to make some money.

Read on to find out more.

What is arbitrage, in simple words?

The meaning of arbitrage in finance is the practice of taking advantage of price differences between two or more markets. In other words, it’s buying in one market while simultaneously selling in another. The idea is to profit from temporary differences in pricing.

The value of arbitrage

These differences in pricing are created by market inefficiencies, which means that the market price of an asset doesn’t reflect its true value – it may be too expensive or too cheap.

Market inefficiencies can be due to a number of things, such as differences in how two markets are regulated or the time it takes for information to travel between them. It’s thought that arbitrage is a really useful activity since it gets rid of these inefficiencies, and assets can then be sold at a fair value, although this is often in the eye of the beholder!

Is arbitrage trading still possible?

Arbitrage trading is always possible because there’s no such thing as a 100% efficient market. However, arbitrage opportunities don’t last long because as soon as the price difference is spotted, traders will buy an asset at a cheaper price, which drives the price up. They’ll then sell at a higher price, often in a different market, and make a profit from the difference. Alternatively, they’ll sell the asset at a high price and buy it back at a cheaper one.

Is arbitrage investing legal?

Yes, arbitrage investing is completely legal, although some people think it sounds a bit dodgy! It’s actually really helpful because it adds ‘liquidity’. In other words, it allows you to convert assets into cash much more easily, making it easier for people to buy and sell. I like to think of it as oiling the wheels of a market. For this reason, far from being illegal, it’s actually encouraged.

Is arbitrage really profitable?

Arbitrage can be a really great way to make money. It’s sometimes described as being ‘risk-free’ because you’re not betting on which direction the market will move in – you’re simply exploiting a price difference. However, no investment is ever risk-free, not even leaving your money in a bank.

It’s also important to remember that arbitrage opportunities are rare, and they don’t last long. So, if you spot one, you need to go for it straight away!

What are the 3 types of arbitrage?

There are three main types of arbitrage:

1. Spatial Arbitrage

2. Regulatory Arbitrage

3. Statistical Arbitrage

Spatial arbitrage is when you take advantage of price differences in markets in different geographical regions. For example, you might buy stock in the US because it’s cheaper than in the UK and then sell it in the UK for a profit.

This type of arbitrage is sometimes called locational arbitrage and is often used in crypto markets. For example, you could make money from the difference and supply and demand of erythreum in the US and UK.

Regulatory rate arbitrage occurs when an arbitrage – usually a firm – exploits loopholes in different regulatory regimes to avoid unfavourable regulation. To do this, firms will use tactics such as financial engineering, restructuring financial transactions or even moving to a country with more accommodating regulation. For example, a company may relocate to the Cayman Islands to keep its business taxes lower. Although this is completely legal, many people think this is unethical.

Statistical arbitrage is often used by institutional investors to take advantage of statistical patterns in the market to make a profit. It’s actually a group of strategies that are used to invest in a wide variety of assets for a very short time and capitalise on price fluctuations. It’s hugely analytical and requires many computer models and lots of analysis.

There are many other types of arbitrage, too, such as municipal bond arbitrage (buying tax-exempt bonds and selling taxable bonds), currency arbitrage (buying and selling currency pairs from different brokers), and triangular arbitrage (using exchange rate differences between three foreign currencies). All types involve reacting to information before it’s more widely known.

Essentially, arbitrage is a way of capitalising on price differences before anyone else spots them!

So, what is social arbitrage?

Social arbitrage, however, is the idea that the people we associate with have an impact on the financial decisions we make. It’s a more formal name for ‘keeping up with the Joneses’ as we say in the UK. If we have frugal friends but are really happy, then effectively, we’re in social profit! Alternatively, if we have to spend loads of money to have a good relationship with people, then we may be running a social deficit.

What is a social arbitrage investor?

A social arbitrage investor uses personal associations and conversations to spot social trends before others have noticed. Once they’ve identified a social trend, they will then invest in the company that is behind the trend. This type of investing is also known as social information arbitrage.

How does social arbitrage investing work?

Investors will often use social media platforms, such as Twitter or Reddit, or other online analytics, such as Google Trends, to identify products or companies that people are interested in. They analyse these terms to find a new cultural shift in behaviour or a market for a product that suggests a positive impact on a firm’s stock price long before market analysts have identified it. This presents an opportunity to buy a stock at a good price before analysts create the demand for it, which will raise the share price. Once this happens, social arbitrage investors then sell the stock and make a profit.

For example, in early 2020, there was a spike in searches for the term ‘toilet paper’ on Google. This suggested that people were stockpiling toilet paper in case of a Covid-19 pandemic. A social arbitrage investor would have identified this trend and then bought stocks in companies that make toilet paper.

Why is social arbitrage investing important?

Many commentators have suggested that social arbitrage investing is important because it’s a way of making money from social media and capitalising on opportunities.

No doubt it’s worked for some. However, I think it’s important for two different reasons:

  1. It helps you to identify a market for a business which is necessary when analysing a firm; and
  2. It helps you to understand when a share price is driven by hype and not by the soundness of the company behind it (overvalued).

In other words, being aware of people who are using the social arbitrage investing strategy means you can be a little more sceptical of market stock pricing, which could reduce your risk of losing money when investing. It’s also one of the processes we should use when making a decision about which company to invest in.

How risky is social arbitrage investing?

There is a risk that social arbitrage investors will buy into a company too early, and the share price will not go up as they expect. This is because they’re basing their investment on social media trends which can be notoriously fickle.

What’s more, if a social arbitrage investor spots a trend and buys shares in a company, they may not be the only one. If lots of social arbitrage investors start buying shares in the same company, then it’s likely that the share price will go up. However, this doesn’t mean that the company is necessarily a good investment; it just means that there’s lots of hype around it, and at some point, that hype will disappear, along with the stock price (remember GameStop?).

And, of course, there’s always the risk of waiting too long to sell the shares, by which time the stock price has plummeted again.

So, while social arbitrage investing can be a way to make money, it’s also important to be aware of the risks.

Pros and cons of social arbitrage investing

Before deciding whether you want to try out social arbitrage investing, it’s a great idea to consider the main strengths and weaknesses of the strategy.

Pros:

  1. It’s relatively easy, and you don’t need to know about company finances to make an investment decision;
  2. Social arbitrage investing encourages you to take note of what’s going on in the world (and on Twitter…).
  3. It can help you to understand when a share price is being driven by hype.

Cons:

  1. There is always a risk you can lose your money when investing – even when saving. Social arbitrage investing is no different.
  2. Putting your money into a company where you don’t know the financial situation is not a good idea, in my opinion.
  3. There is no guarantee that a stock’s price will be affected by ever-changing popular trends. Consequently, social arbitrage investing is quite speculative. (Is it really investing?)

If, after some consideration, you still want to give it a go, then you need to know how to find arbitrage opportunities, which means finding trends before others do.

How to detect meaningful changes before others?

Quite frankly, there’s no easy way of doing this, but it’s necessary if you want a chance to gain an information advantage over a financial analyst. So, it’s a matter of constant attention to current affairs, business news, and social/retail trends.

Tools you could use to help with this include social media platforms such as Twitter, social investing forums such as those on Reddit, and keyword popularity tools like Google Trends and Stocktwits. See if you can spot an up-and-coming trend.

It’s then down to you to do the analysis and determine whether this will have an impact on a company’s share price.

Example of a successful trade

One advocate of social arbitrage investing is trader Chris Camillo. He’s done really well with this approach. (NB. He describes himself as a trader, not an investor…)

In 2019, Chris spotted a review about E.L.F. Beauty Inc from beauty YouTuber jeffreestar who had about 17 million subscribers at the time. Chris realised that millions of people would buy products from E.L.F. based on this review and bought shares and call options in the firm. He was optimistic that this was a potential arbitrage stock.

Over the next six months, the stock price of the company more than doubled from about $8 to $17.5, meaning Chris could sell the shares and make a large profit.

However, it was his call options that really made it for him. They allowed him to buy the stock cheaply at a specified time in the future before selling it at the market rate once the share price has shot up. A bold move and not one for the faint-hearted. You need a lot of confidence in your decision to do this. Luckily for Chris, it worked out.

The Bottom Line

Despite the spin, social arbitrage investing is not a new way to invest. It’s just another way of gathering information that could be useful to an investor. As legendary investor, Peter Lynch stated in his book, One Up On Wall Street, having an information edge is key to a successful investment. Social information arbitrage can help to provide this.

However, the really key part of the process is the analysis that leads a potential investor/trader to decide whether this new piece of information is likely to have a positive impact on a stock’s price. And then back up the decision with cash. This is down to individual judgement. A sound investment decision will look at a company’s strategy and financial position too. Finding a trend is one thing; deciding whether a company is able to capitalise on it is quite another!

Have you ever considered social arbitrage investing? What do you think of it? Let me know in the comments below!

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