In case the futures price are greater then cash price plus carry cost then sell the overpriced futures contract, buy the underlying asset in spot market and carry it until the maturity of futures contract. This is called "cash-and-carry" arbitrage. If futures are trading at discount to the spot then buy the under priced futures contract, short-sell the underlying asset in spot market and invest the proceeds of short-sale until the maturity of futures contract. This is called "reverse cash-and-carry" arbitrage.
If an option is trading with a low implied volatility in other words if the option is cheap have low time premium , then buy the option and simultaneously hedge it by short-selling the underlying stock. Thus locking in the profits over time as the actual volatility exceeds the implied volatility. Similarly if an option is trading with a high implied volatility in other words if the option is expensive have high time premium , then sell the option and hedge it by buying the underlying stock.
Thus locking in the profits over time as the actual volatility reverts back to the historical implied volatility. The amount of underlying to be bought or sold depends on the hedge ratio also called delta of the option. Delta is the rate of change of the option price per unit change in the underlying. However, this strategy involves continuous adjustment of the delta to keep the position delta neutral. Statistical Arb: Statistical arbitrage is based on relative value with an approach of mean reversion.
Statistical arb, also known as pairs trading, involves two highly correlated stocks, in other words, finding two stocks whose prices have moved together historically.
When the spread between them widens, the overvalued stock is shorted and simultaneously the undervalued stock is bought. Profit is made when prices converge and the spread narrows. The key element for the successful implementation of this strategy is finding two or more stocks, sectors, indices that are highly correlated. Pairs trading also works on divergence wherein the spread between the two securities is narrow and the bet is taken on the divergence of the stock. In this case profit is incurred when the spread between the two securities widens.
Index Arb: In an efficient market, two assets with identical attributes must sell for the same price, and so should an identical asset trading in two different markets. If the prices of such an asset differ, a profitable opportunity arises to sell the asset where it is overpriced and buy it back where it is under priced.
In index arbitrage, profit is locked in from temporary discrepancies between the prices of the stocks comprising an index and the price of their index futures. Reliance is trading at Rs. You buy Reliance in cash equivalent to the lot size and sell one lot of Reliance futures.
The profit of Rs. Now let us take another example. The Nifty spot is at 15, and the Nifty futures is at 15, That is a points clear arbitrage profit or close to bps in a month. But there is a problem. How do you capture this arbitrage? You cannot technically buy the Nifty. The answer is index arbitrage where you buy the Nifty as a single basket on one side and simultaneously sell Nifty futures to lock in the index arbitrage spread.
Effectively, the index arbitrage is a stock index arbitrage where you buy the components of the Nifty in the same proportion. Since that is not practical manually, it is done through algorithms and program trades. Let us look at what is index arbitrage and how index arbitrage trading works.
The detailed explanation below will help to understand what is index arbitrage as a concept and how index arbitrage trading happens in practice. Day trading is when you buy and sell stock within a single day Hedging strategy What is a hedging strategy? A hedging strategy is the practice of purchasing and holding Want to learn more about CFD trading? Show me. Latest video. New to trading?
Learn to trade with Capital. Related articles. Market close: US benchmarks closed mixed amid rising inflation by Joseph Toppe. Still looking for a broker you can trust? Market updates. Trading guides. Owner Why Capital. Partner with us. Apply market research to generate audience insights. Measure content performance. Develop and improve products. List of Partners vendors. Index arbitrage is a trading strategy that attempts to profit from the price differences between two or more market indexes.
This can be done in any number of ways, depending on where the price discrepancy originates. It may be arbitrage between the same index traded on two different exchanges, or it may be arbitrage between two indexes that have a standard relative value that has temporarily diverged from its standard.
It can also be arbitrage between the instruments that track the index e. The strategy of index arbitrage is executed by buying the relatively lower-priced security and selling the higher-priced security with an expectation that the two prices will eventually match again or be equal. Index arbitrage is at the heart of program trading , where computers monitor millisecond-changes between various securities and automatically enter buy or sell orders to exploit the differences that theoretically shouldn't exist.
It is a high-speed, electronic trading process that is more often pursued by major financial institutions because the opportunities are often fleeting and razor-thin. All markets function to bring buyers and sellers together to set prices.
This action is known as price discovery. Arbitrage might connote unsavory dealings used to exploit the market, but it actually serves to keep the market in line. For example, if news creates demand for a futures contract, but short-term traders overplay it, then the index does not move. Therefore, the futures contract becomes overvalued. Arbitrageurs quickly sell the futures and buy the cash to bring their relationship back in line.
Arbitrage is not an exclusive activity of the financial markets. Retailers can also find lots of goods offered at low prices by a supplier and turn around to sell them to customers.
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