Arbitrage

Trading futures contracts presents a wealth of opportunity for investors, especially those with larger portfolios and interests across different asset classes. A popular tool for hedge funds and institutional investors, futures contracts add a degree of flexibility to trading that isn’t afforded to the same extent by many similar instruments, and opens up windows of opportunity that otherwise wouldn’t exist. One of those opportunities lies in the technique known as ‘arbitraging’, which helps traders reduce the nominal risk of their investments while boosting their chances of returning a trading profit. But what exactly is arbitraging, and how does it work in practice?

Arbitraging Defined

Arbitraging it the process of taking two different futures positions that deliver a return for the investor, whether the market moves up or down. This is often conducted in the form of one long position and a corresponding short position, which combined allow traders to capitalise on market movements in a less risky, albeit less incrementally profitable way. That said, there are also opportunities for arbitraging two similar positions, so long as the commodity or asset base to which they relate interacts price-wise with the other.

By taking these two complimentary positions, the theory is that one market moving upwards will be sufficient to offset the downwards movement of another, and vice versa, giving the trader the opportunity to profit regardless of the price outcome over the duration of the futures contracts. Additionally, futures can also be combined with other derivatives, such as options, to present a variety of different arbitrage scenarios.

A common example of a scenario in which an arbitrage opportunity can arise is in coupling the S&P 500 stocks with S&P futures. Where there is a difference between the price behaviour of stocks and futures which sees futures rise beyond the corresponding behaviour of stocks, often lasting just a matter of seconds, the opportunity is there to arbitrage the margin between the two. By going short on the S&P futures and long on the stocks, the margin between will give rise to a trading profit, in a much less risky scenario than a non-arbitraged trade.

Finding an Arbitrage Opportunity

The key things to look out for in spotting arbitraging opportunities are an inverse correlation between two futures prices and a suitable price point. The correlation needs to exist such that the movements in one market are likely to offset movements in another market, such that whether prices move up or down the trader is left with a profit percentage. Of course, this has to be balanced with the cost of the transaction, factoring in both the financing costs and the price point of the relevant instruments. As a result, it is often difficult to spot a suitable arbitrage situation, and the dynamic nature of the futures markets means the opportunity may only present itself for a moment before prices correct.

Finding an arbitrage opportunity paves the way for profits at a significantly reduced level of risk for the trader. The trouble lies in actually identifying such opportunities, and it can take many months or even years of practice to be able to identify correlations and likely arbitrage opportunities. Nevertheless, for the trader who spends the research time and understands the pricing components that factor in to determining the arbitrage, the rewards over time can be significant, far outstripping the risks where accurate arbitrage positions are swiftly taken.

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