One of the terms you will often come across as a trader is arbitrage. Arbitrage is the term used to describe the buying and selling of an asset simultaneously in different markets. The asset could be the same or it could be in a derivative form. The pricing difference for the same asset or its derivative leads to a gain for the trader.
So, why does arbitrage happen?
The inefficiencies in the market leads to arbitrage. Inefficiencies could be undervaluation or overvaluation of an asset, owing to a variety of reasons including cost of transactions or human preferences or lack of adequate information. If the market were efficient, there would be no scope for arbitrage.
There are different types of arbitrage, though. Based on the risk involved, arbitrage could either be risk arbitrage or pure arbitrage. Pure arbitrage is free of any risks as it happens only when a trader knows that there is a difference in price. An example of such an arbitrage could be drawn from the forex market. When a forex trader buys or sells pairs of currencies on the basis of their exchange rate at that point in time, it’s a true or pure arbitrage.
Risk arbitrage is based on the likelihood of an event in the future, and involves investors or traders weighing such a possibility. Risk arbitrage is also called merger arbitrage because there is the purchase of stocks during a merger and acquisition.
There are different classifications of arbitrage, and hence different types of arbitrage involved. One classification includes:
Financial arbitrage: Financial arbitrage typically refers to forex arbitrage trading.
Statistical arbitrage: This method of arbitrage involves extensive usage of data and statistics to tap into movement of price.
Dividend arbitrage: This is an arbitrage type wherein a trader (in the options market) purchases stock and an equal number of put options before the next dividend date. (ex-dividend). Dividend arbitrage is also called an options arbitrage strategy.
Convertible arbitrage: This is one of the most popular types of arbitrage and is all about buying a security that’s convertible and short-selling the stock underlying it. A convertible security refers to a security that can be converted into another kind of security. For instance, it could refer to a bond that can be converted/exchanged into a company’s shares.
Arbitrage in the futures market
The futures market, wherein futures contracts are traded, also provides an opportunity for arbitrage. The arbitrage here is called cash and carry arbitrage.
- Cash and carry arbitrage is a form of financial arbitrage wherein a trader buys the underlying asset in the cash/spot market and sells the future of that asset. Cash and carry arbitrage takes place when the price of the asset in the future is greater than its price in the cash market.
- Reverse cash and carry arbitrage is the flip of cash and carry. In this type of arbitrage, a trader buys an underlying asset and sells it short. The asset is bought because it is underpriced and sold because it is overpriced.
Arbitrage in the case of the futures market occurs because of the very nature of a futures contract. Although an underlying asset and its future contract have the same pricing on the expiration date of the future, or close to the expiration, they are not priced in the same manner during the period leading up to the expiration. The difference in prices is what is made use of in an arbitrage.
With the help of all these types of arbitrage trading, a trader or investor has the opportunity to gain by way of pricing differences.
Arbitrage trading, especially in the futures segment, is popular because of its low risk and inherent simplicity.
What is index arbitrage?
Index arbitrage, also known as index arbitrage trading, is one style of arbitrage wherein an investor attempts to make a profit from the difference in the actual price of the stock and the predicted or misrepresented futures price. When index arbitrage trading is successful, the investor can make a gain by exploiting these inefficiencies in the market. The time span to carry out an index arbitrage strategy is very lean due to the current price simply not reflecting the most recent information about the particular currency.
Some traders may refer to index trading as ‘basis trading’. You might have heard it being mentioned in conjunction with day trading strategies where a trader will buy and sell a security or group of securities within the same trading day. When it comes to index trading, to help identify market inefficiencies, investors make use of program trading techniques that monitor a stock index as well as any futures contracts that are on it. If they spot a difference, they can seamlessly execute the order automatically by simultaneously buying or selling the future or the stock.
Example of Index Arbitrage
Suppose a trader comes across futures for Nifty and buys (sells) them while simultaneously selling (buying) the stocks that underlie the Nifty. This way she can earn gains by capturing the difference of the temporarily inflated basis between both baskets. The point at which the price difference exists is often expressed at the block call.
Challenges Associated with Index Arbitrage
Retail investors find the ideal of arbitrage incredibly attractive due to the promise of easy money. However, the possibility of risk versus reward should be realistically considered. In case you are an individual investor or retail investor, you may find it tough to make a profit from index arbitrage in the following situations:
- A small window of opportunity: As mentioned above, the time which requires action when one is dealing with two different quotes is quite small. This is particular for when someone is working manually and not using software for their index arbitrage trading. Hence, one has a small window of opportunity to benefit from when it comes to index arbitrage. The quoted price at which one wants to sell off their securities could change at any second and turn into a lost opportunity or a potentially huge loss for the trader. Due to the high volumes traded, this could become costly. Hence, with arbitrage, there is not much time to think and simply act by selling off shares as quickly as possible.
- Sophistical systems and technology may be required: Program trading is one way in which opportunities for arbitrage are predicted so one can take advantage of differently quoted prices in the future. Manually predicting these opportunities is near impossible for beginners. Those who engage in statistical arbitrage use a series of calculations to estimate the perfect opportunity. Hence, for those who are not willing to commit the majority of their time to estimate when an arbitrage opportunity will crop up, using trading software seems to be the only other option.
- Since index arbitrage requires simultaneous buying and selling of stocks, one’s transaction costs can be high. Transaction costs can occur every time one buys and sells a security, depending upon one’s brokerage. Arbitrage involves buying and selling in high volumes which can prove costly. To match the quotes available on different markets, the volume of shares bought and sold should match a certain amount and this becomes restrictive as one’s transaction costs increase with more volume bought and sold.
Arbitrage occurs because of the inbuilt inefficiencies in the market and involves tapping into the price differentiation between an asset in one market and the same or its derivative in another market. Some of the most popular types of arbitrage include cash and carry arbitrage, and reverse cash and carry arbitrage. These involve an asset and its future contract, and by taking short or long positions depending on the price, traders stand to gain from the difference in prices ahead of expiration date. There are different types of arbitrage trading, and if you would like to make the most of them, you would need to understand the workings of each market and the nature of the asset involved.