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Cash-and-carry arbitrage is a trading strategy used to potentially profit from a price difference between an asset’s spot price and its futures price. The idea is to lock in the price difference between the two markets.
If the futures contract is trading at a sufficiently higher price than the spot asset, a trader may buy the asset today, hold it until the futures contract expires, and deliver or sell the asset against the futures position.
This article talks about cash-and-carry arbitrage in detail.
Key Takeaways
- Arbitrage profitability requires the futures premium to comfortably exceed your total holding and transaction costs.
- Both legs must execute simultaneously to prevent slippage from eroding the locked-in spread.
- Indian stock futures enforce mandatory physical delivery, meaning exact lot-size matching in your Demat account is compulsory.
- Financing the spot purchase via leverage introduces margin risks and interest costs that must be factored into net returns.
- Reverse cash-and-carry is exceptionally difficult to execute in India due to severe short-selling and lending constraints.
What Actually Creates the Opportunity?
A stock's futures price and its spot price are not meant to be identical. Holding physical shares over a period involves carrying costs: capital financing charges, brokerage, and exchange fees.
The futures price normally trades above the spot price to reflect this time value, a state known as contango.
An arbitrage opportunity opens when the futures price runs significantly ahead of fair value (spot price plus genuine carrying costs). When that gap exceeds your cost of carry, buying spot and shorting futures locks in a spread that subsequent market movements cannot touch.
Also Read: How Arbitrage Trading Works?
Working out the Profit
The calculation model is straightforward:
Arbitrage Profit = Futures Price − Spot Price − Total Carrying Costs
Example
Spot price: ₹2,400 per share
Three-month futures price: ₹2,475 per share
Total carrying costs (brokerage, financing, taxes): ₹25 per share
Lot size: 500 shares
Step-by-Step Breakdown:
Gross spread: ₹2,475 − ₹2,400 = ₹75 per share
Net profit per share: ₹75 − ₹25 = ₹50 per share
Total profit on one lot: ₹50 × 500 shares = ₹25,000
Whether the stock rallies to ₹3,000 or drops to ₹1,800 makes no difference. The short futures position obligates delivery at ₹2,475, and the cash purchase was secured at ₹2,400.
Executing the Trade in the Right Order
- Spot the gap: Compare the live futures price with fair value, adjusted for realistic carrying costs.
- Buy the cash shares: Purchase the precise underlying quantity through your Demat account using cash or approved margin trading facilities (MTF).
- Sell the futures leg simultaneously: Short an equivalent quantity of futures contracts to match your holdings precisely.
- Hold to expiry and monitor margins: Maintain adequate margin balances throughout the holding period. Note that broker systems enforce intraday peak margin checks, meaning futures volatility can trigger unexpected margin calls.
- Settle on expiry day: Deliver physical shares from your Demat account to close out the short futures position cleanly.
Why Indian Physical Settlement Changes the Calculus?
SEBI mandated physical settlement for stock futures to curb speculative excesses. This operational framework introduces strict requirements:
- Compulsory lot-size matching: If a contract lot is 500 shares, your Demat account must hold exactly 500 shares. Mismatches leave unhedged exposure or invite heavy auction penalties from the exchange.
- Full capital commitment: Carrying a position through to expiry requires funding the full contract value, not just the initial derivative margin. Consequently, many traders square off the position early once the basis narrows sufficiently.
Cash-and-Carry vs Reverse Cash-and-Carry
When futures trade below spot due to pessimism, the market enters backwardation, enabling reverse arbitrage.
| Feature | Cash-and-Carry | Reverse Cash-and-Carry |
| Market Condition | Contango (Futures > Spot) | Backwardation (Futures < Spot) |
| Spot Position | Buy shares in cash market | Short-sell shares |
| Futures Position | Short futures contract | Long futures contract |
| Main Driver | Futures priced above fair value | Futures priced below fair value |
| Primary Constraint | Capital or credit for spot purchase | Complex short-selling and SLB rules |
Note: Reverse cash-and-carry is impractical for most retail participants in India due to intraday short-covering rules and Securities Lending and Borrowing (SLB) friction.
What can Erode the Spread?
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Basis risk: Exiting prematurely due to margin pressure can force you to unwind at an unfavourable spot-futures spread.
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Execution slippage: Delayed fills on either leg shrink your initial margin of safety.
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Escalating financing rates: Rising short-term borrowing costs can outpace your budgeted carry expenses.
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Transaction taxes: Brokerage, STT, and stamp duty apply across both legs and must be netted off.
Conclusion
Cash-and-carry arbitrage is conceptually simple but operationally rigorous in Indian markets due to physical delivery mandates. While the spread is locked in at execution, ultimate profitability hinges on execution quality, careful handling of carrying costs, and robust margin management.
