Arbitrage in trading refers to leveraging the difference in prices between markets. Futures arbitrage would refer to leveraging the price difference between an underlying asset and the price of the asset’s future contract. All derivative instruments that are created on an underlying asset can show mispricing every now and then. With the help of tools and techniques, traders can spot the mispricing and use the difference to their advantage. A common arbitrage strategy used is cash future arbitrage. Here, the cash refers to the cash or spot market.
So, if you are wondering what exactly is cash future arbitrage, read on. It is a chance to make use of a difference between price of cash and future contract, particularly so at the start of the month. This difference between cash and future price is known as basis. As the expiration date approaches, both the future and spot prices are similar. But the time leading up to the expiration date, ie, during the period of the arbitrage, there is a difference in pricing. When the basis for an asset is negative, it signifies that the asset price is expected to go up in the future. If the basis is positive, it means the spot or cash price is higher than the future price, and indicates a bear run in the future.
If you are into cash to future arbitrage, you would closely track the basis to check if it is higher than your cost of the trade. On paper, a futures contract that comes that has a much later expiration date may hold more uncertainty as there are chances for fluctuations in price, and therefore the basis is higher. Such futures may also be costlier than the underlying asset. With passage of time, the basis drops until it becomes zero or close to zero, and then the expiration date arrives.
Some points to consider while looking at cash future arbitrage include:
- When the futures trade at a premium (higher) than the spot or cash market, the term used is contango. Premium is largely used in the equity derivatives market, while contango is more often used in the commodity derivatives segment.
- When futures trade at a discount (lower) than the cash market, it is called backwardation. The term backwardation is largely used in the commodity derivatives market but both discount and this term mean the same.
- When the discount widens, it is reflective of a bearish trend in the market.
- When the premium increases, it shows that there is a bullish market in the offing.
Cash futures arbitrage example
Consider a stock X as of January 1, 2020. Its cash market price is Rs 150 and its May futures is Rs 152. Say the multiplier of the contract is 100 shares. Imagine that there’s a cost of carry, which is an interest of 8 per cent per annum or 0.75 per cent per month. In such a scenario, the fair price is computed by making use of the formula where F = S*exp(rT) where S stands for the spot price, r is the cost of carry in percentage and T is the time left for expiration in years. So in this example, the fair price is equal to 150*exp (0.0075*5/12), which gives us a number of 150.469. So, this means that it is an overvalued futures contract (market price is at Rs 152). So, you go long in the cash market and short in the futures.
If a trader has 100 shares of this stock and the stock price goes up to Rs 155, the profit would be 155-150×100, which is Rs 500. The futures would set you back by 155-152×100, which would result in Rs 300. So, the arbitrage fetches the trader Rs 200. The cost of this arbitrage is Rs 0.469, which for 100 shares would be Rs 46.9. Your overall gain would be Rs 200-Rs 46.9. This would be Rs 153.1.
On the other hand, if you assume that the Rs 150 stock X drops to Rs 148. In such a scenario, the loss on the underlying asset would be Rs 200 (for 100 shares). The futures profit would fetch Rs 400 (152-148) for 100 shares. The arbitrage would bring you Rs 200. If you were to cut out the cost of carry, then you would have to deduct Rs 46.9 from the Rs 200, which would bring you Rs 153.1. This cash futures arbitrage example shows the inherent simplicity of the trading strategy.
As this cash futures arbitrage example shows, futures provide an opportunity for traders to leverage pricing differences and gain in a relatively risk-free manner. Simplicity is at the heart of the cash to future arbitrage strategy.