Risk in long-short arbitrage

Long-short equity is an investing strategy that involves buying long a security that you feel is undervalued while selling short a related security that you believe is overvalued. An arbitrage opportunity arises when the securities are directly related to one another. For example, when a parent company owns a stake in another company that has a market cap larger than the parent's current total market cap (e.g. Creative Computer's stake in Ubid in 1998). Clearly, either one or both of these securities isn't priced properly.

But, because the market doesn't correct for this behavior instantly there is risk in taking these positions. If the prices of the securities move in the wrong directions before reaching equilibrium at their fundamental value, you face the risk of a margin call, which can force to liquidate your position before capturing the market discrepancy.