Perry Glasser

Arbitrage and Bookies

In Business, Economics, Economy, Finance, Personal Finance, Wall Street on June 7, 2010 at 9:17 am

Joe the Bookie, who was a friend of my father’s, explained to me when I was a naïve but ambitious lad that in the days before the official betting line was emanated from Las Vegas, every punter hoped to find a middle. It happened most often with sports bets, when home town fans addicted to sentiment so lopsided a book that the odds no longer reflected reality. “Say your Yanks are playing your Red Sox,” Joe explained. “In Beantown, taking the Sox to will earn you paying pennies because so many hometown heroes are betting with their hearts, so you take the Yanks at maybe two for one. Are you following me, kid? Now you hustle your ass to Manhattan where the same thing is true—but in reverse. In the Big Apple, you can get two to one, but on the Sox.”

“Yeah, So?”

He slapped my forehead.

“So you take both bets. Who the hell raised you?”

“I don’t get it. How does that help me?”

“Follow me carefully,” Joe said, folding his newspaper, The Racing Form. “You bet $100 in New York and $100 in Boston, right?  You put out a total of $200.”

“Right.”

You have to win one of those bets. At two for one, how much do you get paid off?”

“Two hundred,” I said.

“That’s your profit, kid. Don’t forget you get your wager back.”

“So I get $300.”

“Right. And how much did you risk?”

“Two hundred….oooooh, I see.”

“You had a middle. Doesn’t matter who wins or who loses, you are coming away $100 to the good.”

“Sounds great.”

“Naaah. It’s a nightmare, kid. How long before we’d have to close up if punters won every dime?”

My father sent his boys to public schools: Joe sent his kids to Yale.

Joe’s boys now performs arbitrage for international hedge funds. They’ve got computers that all day long look at bundled investment vehicles: mutual funds, index funds, ETFs, derivatives, whatever—and compare that to the actual prices of the underlying assets—vanilla stocks and bonds.  When the price of the bundle is out of whack with the underlying issues, they move a few billion dollars one way or the other, buying the bundle while selling the underlying issue, or vice-versa.

A few pennies times a few billions makes a nice day’s pay.

By the way, you can only play this game if you have proprietary software and a monster computer that is plugged into world markets 24/7.

When enough computers see a middle—or speculators create one—they mindlessly perform the trades and you get your Flash Crash.

In Joe’s day, anyone who disrupted the game that badly would be swimming with concrete overshoes.

Today, their shenanigans get rationalized in the Wall Street Journal.

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