In the economic systems in place across the world, nearly everything can be bought or sold for a price. It’s this principle that has given rise to many financial markets such as the equity market, the currency market, and the commodity markets. In this last segment, commodities of different kinds are traded for a price, often in bulky, wholesale quantities. While many businesses purchase commodities from the commodities market for their operations, there are also many traders who profit from buying and selling commodities in these markets.
Here’s where the concept of commodity arbitrage comes into play. Arbitrage is, in essence, the practice of buying and selling one or more assets to profit from the difference in the prices. There are different ways to make use of arbitrage in the commodity market. To understand arbitrage trading in commodities better, let’s take a clear look at the different strategies used to carry out arbitrage in the commodity market.
Cash and carry arbitrage
Cash and carry arbitrage is essentially the practice of taking advantage of the difference in the price of a commodity in the spot market and the futures market. For instance, take the commodity that is very popular in the markets – gold. Assume that it’s trading in the spot market at Rs. 50,000. Its one-month futures contract, however, is priced at Rs. 52,000.
To execute arbitrage trading in commodities using the cash and carry method, a trader will have to purchase the asset in the spot market at Rs. 50,000 while simultaneously selling it in the futures market at Rs. 52,000. The trader will then hold the asset in the spot market till the expiry date, and then sell it if required while correspondingly squaring off the short position, thereby minimizing the losses, if any.
This strategy basically helps a trader account for market fluctuations that may not be easy to forecast. It comes in handy when traders find it difficult to predict if the trend in the near future may be upward or downward.
Spread is a kind of commodity arbitrage that involves making use of futures contracts alone. Here too, a trader takes opposing positions, both of which are in the futures market. For instance, let’s take the commodity crude oil as an example. Say the October 2020 futures contract for the commodity is trading at Rs. 3,200, while the December 2020 futures contract is trading at Rs. 3,000. If a trader expects that the difference of Rs. 200 would increase at the time of the October contract’s expiry, it would be a good strategy to buy the October contract and sell the December contract. By squaring off the two positions, it may be possible to book a profit of Rs. 200.
On the contrary, if a trader expects that the difference of Rs. 200 would decrease at the time of the October contract’s expiry, it would be a good strategy to sell the October contract and buy the December contract.
Inter-exchange arbitrage in the commodity market
Arbitrage trading in commodities can also be carried out using the same commodity, but on two exchanges. If there is a difference in the prices of a commodity between two exchanges, it can be used as an opportunity for commodity arbitrage. Let’s discuss an example to drive home this point better.
Say the price of gold for an October 2020 futures contract is around Rs. 50,100 per 10 grams on the MCX. And on the NCDEX, say that a similar futures contract with an October 2020 expiry is priced at Rs. 50,400. Now, a trader can profit from these prices by buying the contract on the MCX and selling it on the NCDEX.
Inter-commodity arbitrage in the commodity market
As is evident from the name, this strategy for commodity arbitrage wherein a trader takes two different commodities on the same exchange, often in the same category. This strategy comes to the rescue when traders are unsure of the way the market may move over a given time frame. For instance, if the price of gold mini for the October 2020 futures is Rs. 52,000, but the price of gold for October 2020 futures is Rs. 54,000, a trader can profit from this difference.
To successfully execute commodity arbitrage strategies, traders must study the price movements of the commodities they intend to trade in carefully. It’s best to do adequate research and account for all possible outcomes before entering into arbitrage trades.