Arbitrage is a currency trading method that takes advantage of a market's lack of perfect efficiency. The purpose of this technique is to profit from the small gap between the bid and ask prices of the same or similar assets. Arbitrage is a well-known method used by a wide range of traders, from novices to hedge fund managers.
It personifies the adage of "buying low and selling high." Typically, an arbitrage entails purchasing an asset from one location or at one time and then selling it in a different market or at a different time in the same market. If the trader can acquire the currency at a low price and sell it for a better price elsewhere, profits will follow.
A prominent approach for trading index futures is "index arbitrage." It entails buying an index and selling the associated index futures contract at the same time.
Fortunately, selling an index futures contract is as simple as purchasing one. A trader must continually detect the difference between an index (such as the S&P/TSX 60 Index) and its related futures contract to execute an index arbitrage (e.g., SXF). The trader will buy the index if the disparity widens beyond a particular point. Simultaneously, the trader will sell the quantity of index futures that correspond to the index's monetary value.
Let's say a trader finds S&P 500 futures and buys (sells) them while simultaneously selling (purchasing) the equities that make up the index. By capturing the difference in the temporarily increased base between the two baskets, he can profit. The block call is a term used to describe the point where a pricing disparity exists.
Index arbitrage is a trading method that makes money by exploiting disparities between one or more versions of an index or between an index and its constituents. The latter is the more popular type of index arbitrage, but keep in mind that it is both money and technology-heavy since it requires complicated algorithms to capture opportunities and low latency execution to achieve the best price. These arbitrage possibilities usually last only a few milliseconds.
Trading terminals, particularly for institutional clients, offer the ability to execute an index basket. When the basket is purchased, all Nifty stocks in the same proportion as the Nifty are purchased, and equal Nifty futures are sold. In order to make the best out of this opportunity, the system might create triggers for when the index arbitrage basket is to be implemented.
In order to be profitable, index arbitrage requires a large amount of capital, high-speed trading, and cheap commissions. This makes more sense for large institutions with the ability to move enormous sums of money for little returns and trade in high volumes. The bigger the number of components in an index, the more likely some may be mispriced, and the greater the index arbitrage opportunities. As a result, a larger index, such as the Nifty 50, is more likely to provide index arbitrage possibilities.
To comprehend index arbitrage, you must first comprehend the concept of index fair value. Fair value - means the equilibrium price for a futures contract in the futures market. The futures price can be defined as the spot price plus the carrying cost. What is included in the carrying cost - the cost of carrying in index arbitrage includes the opportunity cost of compounded interest and dividends missed because the investor holds a futures contract rather than equities.
Typically, index arbitrage is used when a futures contract trades significantly below its fair value. The word "significantly" is used here. Small deviations from fair value cannot be traded because it needs cash, incurs brokerage expenses and statutory costs, and has tax ramifications.