One of the hardest concepts for someone who has never done arbitrage to grasp is the fact that the value of the underlying company is

In this article Id like to walk you through a few ideas around arbitrage:

If youve studied the stock market, you most likely started out by learning how Wall Street values stocks. PE ratios, cash flows, book value, enterprise value, addressable market size and growth projections, etc. etc. etc. etc.

Most people find their favorite one or two of these, and then base their strongly held investing beliefs on their favorite metric.

The media, CNBC, The Wall Street Journal, the Motley Fool, etc. reinforce these investing beliefs. They interview experts who use the same language and metrics, so everyone is on the same page.

So you get quotes like this, We did a study and found that historically when the PE drops below 15 that is a signal to buy. Or, Cash flows have been rising consistently for 4 quarters, and we are telling our customers to buy the stock here.

Cool. Got it. Thats how most people think about the stock market.

The stock is a buy at this level because of X, and a sell at this level because of Y. Its how Wall Street and the media sell (either advertising or services) to what they call the dumb money.

Think about that for a minute. Youre educated by Wall Street and the Wall Street media outlets. They tell you what to do based on this education.

And then they LITERALLY call you, as their customer, DUMB.

I cant even think of a good zinger for that one. I guess it stands on its own. Maybe Schwab should make a commercial with the tagline, Youre a moron, just give me your money already.

I could go on for a while on that one, but Ill just let it be.

In arbitrage youre only concerned with one thing.The value of one thing,relative to the value of another thing, OR relative to the value of the same thing in another market.

You can be looking at the value of a stock, warrant, option, car, house or t-shirt. It doesnt matter.

Once you get that concept its pretty simple.

(And, the longer you practice arbitrage, the more adept youll become at spotting patterns in particular arbitrage situations. This is exactly what I relate toWarrant Observermembers. Over 20 years of seeing and identifying these patterns in arbitrage.)

Im a pretty simple dude. I like to fish, play video games, hike, snorkel, and drink a scotch in the winter and G&T in the summer.

Im not really into complicated business model stuff. When it comes to making money to pay for fishing, snorkeling and drinking, the simpler and easier it is, the better as far as Im concerned.

Ive used this analogy before, but I really want making money to be like seeing a $20 bill lying on the ground. If I have to bend over to pick it up, Im happy to put in that effort.

As Ive mentioned recently, thats why I love that my 15 year old is selling t-shirts online. Thats pretty simple stuff man. Drive to the thrift store, buy shirts cheap, sell shirts for a great profit, mail shirts to buyer.

Sometimes she even takes a picture of the shirt at the store and has it sold BEFORE she even buys it. THAT is businessTHAT is ARBITRAGETHAT is SO simple andTHAT can pay for your house, car, vacation, college, I think you get the idea.

I know its that easy to make money. Ive done it over and over.

Not because Im smarter than anyone elseI did OK, and I mean barely OK, in college. One of my most amusing memories is sitting in a statistics class, not being able to understand the Russian teaching assistant.

Two girls were sitting in the row of seats in front of me. One turned to the other and said, Im Russian, are you Russian? I thought, holy crap, everyone in this class understands this guy except me. Im screwed.

A few minutes later, after hearing a little more of their conversation, I figured out she actually said, Im rushing (as in a sorority), are you rushing? That made me feel better.

Even when I was helping NASA take the cost out of their launches (see how saying that makes me seem smart??), it all came down to simple stuff in the end.

Youre doing 15 launches for 15 satellites, Mars missions, etc. What if you launched some of those satellites on the same rocket, saving an entire launch worth of money? Maybe we could even get that 15 launches down to 12? $300M saved, pay the man! You crazy rocket scientists.

When it comes to arbitrage, it doesnt take a lot of smarts to do this stuff. And, it is SOOOO much easier than being the dumb money. Which is kind of ironic I think.

So, thats what arbitrage value is along with the fact that you dont have to be a genius to understand it. It aint rocket science.

But, before we get into the model, lets talk for a second about what makes arbitrage hard for most traders.

Earlierthis year Iwroteabout, talked about, read about, emailed with the management of, and made a lot of money trading the warrants of a company called Phunware (PHUN, PHUNW).

If youve read my blog you know all about it, but if not, lets just say it was a three ring circus of trading in the truest essence of P.T. Barnum.

It had everything. A soaring stock, a warrant that refused to join the stock in the high wire act, a shuttered SEC due to political wrangling, a cool technology (multi-screen as a service, MAAS), dapper management that was tweeting to match Trump (just kidding, no one can match those tweets), and a rowdy big top crowd gathered at , and in various other public spots across the internet, including Twitter.

It was truly some good old fashioned fun. Neither I nor my warrant arbitrage mentor, who has probably 30 more years of arbing warrants on top of my over 20, had ever seen anything quite like it.

In the end, absolutely none of that really mattered. I, and several of my readers, including one who wrote a guest post about hisexperience, made some really good money because of, wait for itARBITRAGE VALUE.

My experience told me the warrants were priced too low relative to the common stock regardless of the circus that was taking place.

Did you see the movie The Greatest Showman? There is one scene in the movie where the building the circus is housed in burns to the ground.

There is a huge crowd gathered watching the building burn. Then Hugh Jackman runs into the building to save Zac Efron. Everyone is glued to the scene.

I felt like I had pulled up on this scene, looked at the ground (which no one else was looking at) and saw that an armored car had pulled up and dropped $100 bills all over the place.

During the show that was Phunware, I had multiple conversations with a number of really smart traders and investors who said things along the lines of:

Do you KNOW how good this technology is? Oh My God. And this company has contracts with Amazon, Walmart, McDonalds and 99% of the top 1,000,000 companies in the world. AND management is TOP Fing Notch. The CEO is from Cisco, is also the architect who built the Apple round building thingy, and Im pretty sure, though no one knows it, craps pure gold.

My reply was always the same. Yeah, I think the warrant is undervalued. And I think the stock is going to come down when the warrant becomes exercisable. Because that is thepatternIve seen over the past 20 years.

And finally, after several hundred percent of gains in the warrant and the stock declining, Yeah, I would probably sell the warrants here, theyre probably going to come down now. Pattern.

It wasnt magic. I didnt have a crystal ball. Remember, I even FAILED statistics in college.

But I can see an arbitrage pattern repeat, and repeat, and repeat. AndEVEN I can make money.

Now, before I get a 1,000 emails saying Im poo-pooing fundamental analysis with my joking quote above, Im not.

Fundamental analysis totally has its place. I just like making money in easier ways than predicting what the next move by brilliant management with brilliant technology will be.

I was a management consultant for years to VERY large corporations. And, Ive seen a LOT of crazy calls by management.

One of my clients built dumb, remote controlled robots to service one of the dirtiest and most dangerous industries out there. Top management recommended to the board that they buy a roller coaster company. Just sayin.

If you are good at fundamental analysis, and can predict when the Fed will raise and lower rates, and when President Trump will tweet good or bad things at a company, and when or if tariffs will go away, and whether the company whose stock you buy has the best tech ever and will become the next Apple, then YOU ROCK. Go get em.

There are lots of ways to make money in the market. I just like the easy stuff with the fewest moving and unknown parts.

And, if that is your focus in a trade, arbitrage, then dont get caught up in ancillary issues that will more than likely negatively impact your profits.

Oh, and PHUN, check the price. Ouchy, as the technicians say.

Now, let me introduce a model I like to use when examining arbitrage opportunities.

I call it the, drum roll please, the Super Complicated Concentric Circle Model. (You can tell your friends its called that at parties so you look smarter than the dumb money, lol.)

Think about dropping a stone in the water. You know how I love to relate trading ideas to water.

When you drop the stone in you get ripples radiating out from where you dropped it. The ripples, or circles, are well defined close to the center and then fade as they get further away.

The first circle is your warrant and common stock. These are obviously very highly correlated, and are the most well defined.

Your next circle out is the next trading vehicle with the highest correlation. If the stock has options, they will be the next circle.

In most cases this will be the next circle you look to for value comparison, and to make money. But not in all cases.

For example, if the options are very thinly traded you may find that trading options against your common or warrant is not the best way to arb the position.

Asimilar stock, same industry, similar in size, customer base, etc. may be more highly correlated than the options on your stock. It could be that trading this stock, or even its options, against your position is a money maker.

Next you could have stocks that are inversely correlated.

You get the idea. As you move further from your inner circle your correlation will be weaker.BUT, you may find that the 3rd or 4th circle out is the most profitable, or perhaps the most liquid, or both.

Look for another post tomorrow where Ill go into more detail on the Concentric Circle Model.

Meanwhile, Friday is quickly approaching, and with it thenext issueof the Warrant Observer newsletter.

Im working on some special bonuses for those who join with an annual membership this week only. Ill drop one of those on you tomorrow when we continue our concentric circles conversation.