Arbitrage is a trading strategy used for currency trading that exploits that lack of perfect efficiency in a market. The goal of this strategy is to generate earnings from the slight difference in the bid and ask price between identical or similar assets. Arbitrage is a well-documented strategy utilized by all kinds of traders, from brand new investors to hedge fund managers. It epitomizes the mantra of ‘buying low and selling high’. Normally, an arbitrage involves buying an asset from one place or at one time and selling it in another market or at another time in the same market. Gains follow provided the trader is able to buy the currency for a low price and sell it for a higher price elsewhere.
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 S&P 500 and buys (sells) them while simultaneously selling (buying) the stocks that underlie the S&P 500 index. 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.