What is Reverse Cash and Carry Arbitrage

Traders are often on the lookout for trading opportunities and make use of different strategies to generate returns. In an arbitrage strategy, traders track multiple markets to benefit from the price discrepancies between the two markets. There are several types of arbitrage strategies that traders can use while trading commodities. In this blog, we will take a look at one such arbitrage strategy known as the reverse cash-and-carry arbitrage.

What is Arbitrage?

Before we explore the reverse cash-and-carry arbitrage in greater detail, let us take a look at what arbitrage is.

Arbitrage refers to a strategy in which traders buy a security in one market and sell it in another market simultaneously. Arbitrage strategies allow traders to benefit from the price discrepancies between two markets.

For example, an asset may be trading at Rs.100 in one market and Rs.102 in another market. An arbitrage trader will purchase the asset from the cheaper market and sell it in the market where it is trading at a higher price to earn a profit.

Since arbitrage involves buying and selling securities at the same time, it helps in stabilizing and aligning prices across markets, making them more effective.

Arbitrage traders often utilise derivative contracts to deploy various strategies. Strategies like the cash-and-carry and reverse cash-and-carry involve positions in the asset along with a contrary position in the futures contracts of the asset.

What is Reverse Cash and Carry Arbitrage?

A reverse cash-and-carry strategy is an arbitrage strategy that has a market-neutral approach. The strategy involves entering into a short position of the underlying asset and a long position in the futures contract of the same asset. Meanwhile, a cash-and-carry strategy is the opposite and involves going long in the spot market and shorting the futures contract of the commodity.

The objective of the cash-and-carry strategy is to benefit from the inefficiencies in pricing between the spot price and the futures market. Through a reverse cash-and-carry arbitrage strategy, traders aim to lock in a risk-free profit by going long on futures and shorting the asset in the spot market.

Traders deploy a reverse cash-and-carry strategy when the futures contracts of an asset are trading lower than the spot price. This is a condition known as backwardation. This is typically seen in futures contracts that are expiring at a later date and are trading at a lower price than the spot price.

Since this condition is abnormal, traders go long on the futures contracts and enter into a short position in the spot market to benefit from the price discrepancy. While trading this strategy, it is also crucial to consider the carrying costs or costs associated with shorting the commodity.

Mechanisms of a Reverse Cash-and-Carry

Let’s look at the steps involved in a reverse cash-and-carry arbitrage.

• Short sell the commodity in the spot market.
• After short-selling a commodity, invest the proceeds at a risk-free interest rate.
• Enter into a long position in the futures market to cover the short position at a lower price.
• The profit is the difference between the spot price, futures price, and carrying costs.

Conditions Required for Reverse Arbitrage

Before trading a reverse cash-and-carry strategy, it is important to ensure to following conditions have been met.

• A trader should have access to the spot and futures market. Since this strategy calls for contrary positions in the two markets, a trader should have access to both.
• The reverse cash-and-carry strategy involves shorting the commodity in the spot market. Make sure you have the necessary margin required to short the commodity. Also, ensure you have access to borrowed inventory which is required to create a short position.
• A reverse arbitrage strategy can be beneficial only if there is a considerable difference between the spot and futures price. The difference between the two prices should be enough to cover carrying costs such as transaction and storage costs.

Reverse Cash-and-Carry: Example

Let’s better understand the reverse cash-and-carry strategy with the help of an example.

The price of gold in the spot market is trading at Rs.90,000 meanwhile the futures contracts expiring a month later are trading at a discount at Rs.85,000.

Seeing this price discrepancy between the spot market and futures market, a trader can enter into a reverse cash-and-carry trade. To execute the trade, the trader will short-sell gold in the spot market at Rs.90,000. The trader will also consider the costs of shorting and carrying the position which amounts to Rs.2,000. For the reverse cash-and-carry strategy, the trader also enters into a long position in the futures contracts at Rs.85,000.

Once the futures contracts expire, the trader will take the delivery of the commodity and use it to cover the short position in the spot market.

Finally, the trader’s profit is: the spot price – futures price – carrying costs.

Profit = 90,000 – 85,000 – 2,000

Profit = Rs.3,000