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Convergence Trade

A convergence trade is a strategy in which an investor takes opposing positions in two related financial instruments that are expected to converge in price over time. The trade typically involves buying the undervalued asset and short-selling the overvalued one, profiting when the prices align. Convergence trades are often used in arbitrage strategies and rely on the expectation that price discrepancies between related assets will diminish.

Example

An investor might buy a stock and short its related futures contract if they believe the futures price is too high relative to the stock, expecting the two prices to converge as the futures contract approaches expiration.

Key points

• A convergence trade involves taking opposing positions in two related assets that are expected to converge in price.

• It is commonly used in arbitrage strategies to profit from price discrepancies.

• Success depends on the expectation that the price gap will close over time.

Quick Answers to Curious Questions

The investor buys the undervalued asset and shorts the overvalued one, profiting when the prices converge.

A typical example is buying a stock while shorting its corresponding futures contract if the futures price is higher than expected relative to the stock price.

The main risk is that the prices may not converge as expected, potentially leading to losses if the price gap widens instead.