I once gifted my boss a scarf that I had bought on a trip to Thailand a few months earlier. It wasn't anything expensive. Just something I bought at a flea market. My boss and several other female colleagues oohed and aaahed over the scarf and one of them even asked me if I was trying to butter up the boss buying her such an expensive gift. I just smiled and nodded, confused. A coworker who knew I had bought the scarf in Thailand was kind enough to explain to me later that scarves exactly like my gift were being sold at boutique shops here in Mumbai for a much higher price. Basically I had earned a whole lot of brownie points simply because of the price difference between Thailand's markets and our markets.
In Cash Future Arbitrage, too, the trader aims to earn by capitalizing on the price difference between cash markets and futures markets. Traders tend to favour Cash Future Arbitrage for its relatively risk-free nature.
This is how it works: The trader observes the cash price (or stock market listed price) and compares it with the futures price (that is the price mentioned in futures contracts.)
There is sometimes a difference in these prices, most commonly at the start of a given month. This difference is known as basis. More on basis in a little while.
The trader will sell futures that are trading at a premium.
Conversely, the trader will buy futures trading at a discount.
Let's look at a specific example together. For instance, a trader will buy stock at Rs 100 per share but buy a futures contract to sell that stock at Rs 120 per share.
How does a trader know when to play what cards in the cash futures arbitrage game? Well, he uses a tool called basis. That's right, I did mention basis earlier today!
As discussed, basis is the difference between the futures price and the stock market price of a given stock (which incidentally, is also known as spot price).
The formula for basis is as follows:
Basis is equal to futures price minus spot price.
"But what if the futures price is lower than the spot price," you ask?
Well in that case, basis will be negative. A trader draws conclusions from whether basis is positive or negative.
A negative basis for any given stock indicates that its price is expected to go up in the future.
A positive basis for any given stock indicates that its price is expected to reduce in the future.
There are some considerations that must remain top-of-mind when an investor are opting for cash future arbitrage.
The costs for buying the option (that is the cost of the premium and any brokerage charges) must not equal or exceed the price difference between the cash price and the futures price.
There is also a cost to keep the stock or security until the expiration date of the contract. More specifically, the investor might be required to increase his margins. This is known as a carrying cost and this cost is dynamic or in other words it is constantly in a state of flux. As a result, cash future arbitrage is relatively risk free but not entirely risk-free. Keep this in mind.
Volume is key to making profits here and as a result, the trader should have a sufficiently large amount of capital if he plans to opt for cash future arbitrage.
Arbitrage is mainly popular because it reduces the number of variables and thereby reduces risk. As a result, investors tend to favour stocks for arbitrage. This is because commodities such as livestock or grain, gold or oil, might add other variable costs thereby defeating the whole "little or no variables" argument. That's not to say that commodities are never chosen for cash future arbitrage - they are simply the less popular choice.
That about rounds up the basic concept and basics of cash futures arbitrage but before you go, there are some key terms related to cash futures arbitrage that you should be aware of. They are:
I'm going to give you a quick and easy explanation of all three.
Spreads basically refer to the price discrepancies or inefficiencies between the markets. These inefficiencies are the whole foundation of cash futures arbitrage, and as a result, the higher the spreads, the better.
Backwardation refers to a situation where the stock market price is higher than the futures contract price. This is a relatively irregular situation. Backwardation is a commodity trader term - stock traders usually refer to backwardation as discount. A higher discount or more backwardation heralds a potential bearish market in the near future.
Contago refers to a situation where the stock price is lower than the futures contract price. This is the term preferred by commodity traders. The same concept is known as Premium among equity traders. A higher premium usually hints at an approaching bullish market.
Although cash futures arbitrage is indeed one of less risk-heavy investment options available on the stock market traders need to keep the usual rules of thumb in mind before investing, namely - consider your risk appetite, do your own research, use stock market tools for research and keep any eye on variables.