What is convergence trade?
Convergence trade is the practice of buying a security with a future delivery date for a low price and selling a similar security, also with a future delivery date, for a higher price. The aim is for the prices of the securities to converge, resulting in profit.
Key takeaways
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Convergence trade involves buying a security with future delivery at low price and selling similar security at higher price, profiting when prices converge.
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Unlike arbitrage which trades identical instruments, convergence trade deals with similar financial instruments that both have future delivery dates.
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The strategy relies on detecting very small mispricings, typically identified by computer programs which are better at detection than human analysis.
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Convergence trade uses high leverage to fund transactions and assumes prices will converge, which represents the strategy's biggest underlying risk.
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While often profitable, convergence trade risks are nearly impossible to detect, and failed convergence can result in substantial financial losses.
Where have you heard about convergence trade?
You might have heard the concept of convergence trade being described as arbitrage. You should be aware that there is a difference, however. While convergence trade deals with trading similar financial instruments, arbitrage is strictly about trading identical instruments.
What you need to know about convergence trade.
While convergence relies on mispricing securities (buying it cheaper and selling it for more), the mispricing is often very small. Misprices are often detected using computer programmes, which are much better at detecting than the human eye.
The biggest risk associated with convergence trade is that you're always assuming that the prices will converge. While the strategy is often profitable, it is near impossible to detect the risks. Convergence trade uses high leverge to fund transactions, and if the securities don't converge, you're at risk of losing a lot of money.