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.
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.