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Arbitrage in trading refers to taking advantage of price differences for the same asset across related markets. Cash–future arbitrage is a trading strategy where traders profit from price differences between a security’s spot price and its futures price as expiry approaches. This gap, known as the basis, naturally narrows (converges) as the contract approaches expiry, creating a profit opportunity regardless of market direction.
Key Takeaways
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Cash–future arbitrage targets the spread (basis) between spot and futures prices in regulated Indian markets.
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Arbitrage is legal and recognised by SEBI when executed within regulatory norms.
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The strategy is relatively low risk because it relies on price convergence, not market direction, but it is not completely risk-free.
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Market structure, liquidity, regulatory rules, and taxation play a crucial role in determining whether an arbitrage opportunity is practical and profitable.
Understanding Cash–Future Arbitrage
Cash–future arbitrage is a strategy that uses price differences between the spot market and the futures market for the same asset. These differences arise due to factors such as cost of carry, interest rates, dividends, and the time left until contract expiry.
Traders aim to benefit from this temporary mismatch, as spot and futures prices tend to converge as expiry approaches. The strategy involves taking offsetting positions in both markets to reduce exposure to overall market movements. When executed with proper cost and risk assessment, cash–future arbitrage helps align prices across markets and supports efficient price discovery.
Key components:
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cash market (spot market): where securities are bought and sold for immediate delivery
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futures market: where contracts are traded to buy or sell securities at a fixed price on a future date
Read More About: Spot Rate
How Cash–Future Arbitrage Works
Cash-future arbitrage leverages pricing discrepancies between the spot price and the price of a futures contract for the same asset. In India, this is widespread in stock and index futures traded on exchanges like the NSE and BSE.
Step-by-step Process
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Identify price discrepancy: The trader looks for a gap between the spot price and the futures price of the same stock. This gap is called the basis and is calculated as the futures price minus the spot price. (Basis = Futures Price – Spot Price)ww
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Take simultaneous positions: The trader buys the stock in the cash market and sells an equivalent futures contract at the same time. Both positions are taken in the same quantity to balance price movements.
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Hold the positions: The positions are held until the futures contract nears expiry or the price difference reduces. During this period, price movements in the cash and futures markets tend to offset each other.
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Close the trades: The stock is sold in the cash market, and the futures position is squared off. The profit is the initial price difference, adjusted for transaction costs, margins, and carrying expenses.
Example
Suppose a stock is trading at ₹1,000 in the cash market and its one-month futures contract is ₹1,020. The arbitrageur may:
Buy the stock at ₹1,000 and sell the futures at ₹1,020.
If the futures price converges to around ₹1,005 near expiry and the stock stays near ₹1,000, the spread can be realised after deducting transaction costs, margins, and taxes.
Note: This example is for illustration, and actual returns depend on costs and market conditions.
Conditions for Cash–Future Arbitrage Opportunities
Cash–future arbitrage opportunities arise when the futures price moves away from its fair value, which is derived from the spot price and the cost of carry. Such gaps are usually temporary and depend on specific market conditions. Key factors that influence these opportunities include:
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Dividends and interest rates: Higher interest rates or expected dividends increase the cost of holding positions, which can reduce the price gap and limit arbitrage gains.
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Duration of the basis: A wider and longer-lasting difference between spot and futures prices offers better profit potential after adjusting for costs.
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Liquidity and volatility: High liquidity ensures smooth entry and exit, while reasonable volatility helps create price differences.
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Transaction costs: Lower brokerage, taxes, and other charges improve the net return from arbitrage trades.
Advantages and Limitations of Cash–Future Arbitrage
Cash–future arbitrage is often viewed as a relatively stable trading approach, but it comes with both benefits and constraints. Understanding these aspects helps traders assess whether the strategy suits their risk and capital conditions.
Advantages
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Low market risk: Since positions are taken simultaneously in the cash and futures markets, price movements tend to offset each other, reducing directional risk.
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Works across market trends: Returns depend on price convergence rather than market direction, making the strategy usable in both rising and falling markets.
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Supports market efficiency: Arbitrage activity helps narrow price gaps between spot and futures markets, contributing to fairer pricing overall.
Limitations
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Transaction costs: Brokerage charges, taxes, and bid–ask spreads can reduce net returns, especially when price differences are small.
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Margin requirements: Futures positions require margin, which can block capital for the duration of the trade.
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Timing uncertainty: Price convergence may take longer than expected, affecting returns.
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Regulatory limits: Trades must follow exchange and regulatory rules, which can restrict execution flexibility.
Factors Affecting the Cash–Future Arbitrage Strategy
Several structural and regulatory factors influence how cash–future arbitrage works in practice, especially in the Indian stock market. Understanding these elements helps traders evaluate feasibility, costs, and execution clarity.
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Cash and future arbitrage in the Indian stock market: In India, this strategy is commonly used to capture price differences between the spot market and futures contracts on indices and large, liquid stocks. It operates within a regulated framework that prioritises transparency and actual delivery for non-intraday positions.
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Market structure: The Indian market is divided into two key segments.
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Cash segment: where shares are bought and sold with actual delivery.
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Futures segment: where contracts are traded for delivery at a future date at a pre-agreed price.
Efficient arbitrage depends on smooth interaction between these two segments and sufficient liquidity in both.
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Regulatory framework: Trading and settlement rules are governed by market regulators and exchanges. Delivery-based rules require actual share settlement, which means same-day buy and sell without delivery is restricted for arbitrage trades. These rules directly shape how and when positions can be created and closed.
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Taxation aspects: Tax treatment affects overall returns. Arbitrage-based equity investments follow equity taxation rules, where the holding period determines whether gains are treated as short-term or long-term. Post-tax outcomes can differ from pre-tax arbitrage spreads.
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Execution tools and costs: Transaction charges, margins, and operational efficiency play a major role. While technology helps identify price gaps quickly, execution speed, funding costs, and margin availability ultimately decide whether an arbitrage opportunity remains profitable after expenses.
Cash Futures Arbitrage Example
Consider a stock X on a given trade date. Its cash market price is ₹150, and its near-month futures are ₹152. Say the lot size of the contract is 100 shares.
Scenario A: Market Goes Up If the stock price rises to ₹155 at expiry:
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Cash Profit: (₹155 - ₹150) × 100 = ₹500 profit.
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Futures Loss: (₹152 - ₹155) × 100 = ₹300 loss.
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Gross Profit: ₹500 - ₹300 = ₹200.
Scenario B: Market Goes Down If the stock price drops to ₹145 at expiry:
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Cash Loss: (₹145 - ₹150) × 100 = ₹500 loss.
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Futures Profit: (₹152 - ₹145) × 100 = ₹700 profit.
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Gross Profit: ₹700 - ₹500 = ₹200.
In both cases, the trader locks in the ₹2 spread. The final net profit would be ₹200 minus transaction costs and the cost of capital (interest).
Conclusion
Cash–future arbitrage is a strategy that focuses on capturing price differences between the spot market and futures contracts rather than predicting market direction. Its effectiveness depends on timely execution, cost control, and adherence to market rules. While the strategy is considered relatively low risk, returns are influenced by factors such as transaction costs, margins, taxation, and settlement requirements.
A clear understanding of how cash and futures markets interact helps traders assess whether arbitrage cash and future opportunities are practical and worthwhile. When used carefully, arbitrage cash and futures strategies support disciplined trading and contribute to efficient price alignment across markets.
