Investors: Emotional Arbitrage

In a market plagued by inexperience, speculation, and uncertainty, here’s my idea regarding current inefficiencies and a way to create value based on more than just quantitative metrics. Although a long read, try to tough it out — the benefits of having this knowledge in your pocket will far outweigh the cost of a few minutes.

Arbitrage is profiting off of inefficiencies in market pricing, taking advantage of differences between a set of current spreads on various exchanges.

Emotional Arbitrage is profiting off of inefficiencies in market emotions & opinions, taking advantage of differences between the current consensus and the realities surrounding it.

Although not necessarily new, it seems that now more than ever investors (speculators) are caught up in the flurry of everyday market information, leaving out the value of foresight and enabling inefficient pricing in the short-term. Things such as earnings reports, company news releases, and public spotlights have taken control of the marketplace, the daily/weekly volatility due to these events aggressively overcompensating for their importance. Being able to see through the market noise and make sound decisions will offer the opportunity to profit from others missteps – it offers the opportunity for emotional arbitrage.

In order to take advantage of emotional arbitrage, you’ll need to start by thinking differently than those around you. I wrote an article a little while ago regarding  Second Level Thinking, a.k.a critically thinking — take a look at it to get a better understanding of the processes involved in effective decision-making.

Now that you’ve gained the ability to see above the smoke, you’ll need to be able to pick emotional inefficiencies apart from important events, being careful not to group all occurrences into the same category. There will be market news that is important and certain stories or reports that will actually carry weight, the opportunity to profit lies in your ability to know the difference.

Here are a few examples of times where emotional arbitrage would have succeeded, the two of them highlighting the value of being able to think & see differently than other market participants.

1. Shopify’s Short Report

I’d be lying if I were to say that Shopify’s stock explosion over the past year is reasonably supported, however potentially overvalued though, they provide a great example of a panic-sale based on news & reports.

Screen Shot 2018-01-06 at 5.36.33 PM

After short-seller Andrew Left released a report on October 2nd stating all of the potential faults & accusations of Shopify, pinned with a future price target of $60 USD, the stock tumbled slightly over 22% during the following 4-day period. The main reason for this price deflation was panic, as it’s 150% price run-up over the past year had left a lot of lined pockets sitting on the edge of their chairs. People were waiting for the straw to break Shopify’s back, and when the short report caught traction it led a lot of holders to liquidate their positions and lock in their profits – fearing a further decline.

The key here is that the short-report didn’t change anything fundamental about the company, not its potential earnings/growth or any of its current successes. It simply acted as a market stun-grenade that threw investors into a panic. The opportunity to see this, let the dust settle, and then scoop up shares/options contracts (if you personally believe in the potential of the firm) was served up on a silver platter.

2. Lululemon’s Amazon Scare

To give a retail-based example, we’ll look to Lululemon’s short-term plummet (and preceding 2-week volatility) that came after Amazon’s entrance into the Athleisure marketplace became common knowledge.

Screen Shot 2018-01-07 at 9.46.42 AM

Within a 4 day mid-October period, LULU shares had declined by just over 8% (on high volume) on the news that Amazon would be their newest competition. This example emphasizes how market news can and will push investors to ignore relevant long-term potential during short-term shocks.

Lululemon is built on the back of its brand, their focus is to sell an idea/lifestyle. Regardless of how cheap Amazon may be able to produce stretchy pants, their inability to create a consumer connection will prevent them from snatching Lulu’s main market. That paired with Lulu’s recent store expansion, consistent earnings growth, and line diversification would be signs that they’re here to stay for a little while longer. Taking advantage of the markets 8%-off coupon on Lulu was visible to those who could see past the short-term market flurry.

Before making decisions, Look at the foundation of the price movements and determine how they line up with the long-term potential of a firm. This will allow you to decide whether or not a missed EPS on last quarters reports, a short-sellers analysis & target price, or a bad press release are any indication of a declining future and will prevent you from getting trampled by the bull/bear herd.

To close, here’s a little checklist you can run through the next time a company you’re following gets hit with an emotional sale. Remember, it’s a fast market that requires detailed thinking, don’t assume every situation will play out the same as those prior.

  • A new market entrant has caught Wall Street off guard and caused a rapid selloff, should this be a cause for concern? Perform a SWOT analysis (pair it with a porters 5-forces to double down) and analyze where the firm sits in relation to its competition (current & potential). If the future looks good (and profitable) after your analysis, consider buying more at a now discounted price – be confident in your convictions.
  • A bad earnings release has shaken the market and caused the price to fall. What was the source of it? If based on things out of the firms’ control (i.e. natural disasters) or due to capital expenditures (i.e. investment for future growth), don’t jump ship just yet. Find the source of the miss and determine whether or not it has underlying implications.
  • A short-report has caused a panic sale, is it worth weathering the storm? Remember that the people releasing these documents have an invested interest in the failure of said company – they will say whatever it takes to pull the stock down. Read the report before dismissing it to determine if they raise any valuable points you may have not considered, if nothing is there, the true value will eventually come back into focus.
  • A negative news release/prediction has frightened investors. How likely is the information in the report to actually affect future potential or hurt profitability? If the findings are based on assumptions or predictions, don’t get hung up – let the dust settle and then determine whether or not you want to change your position.

Happy arbitrage-ing.

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

Create a website or blog at

Up ↑

%d bloggers like this: