Arbitrage Trading

The great attraction of arbitrage trading is that it is intrinsically less risky than ordinary trading, because you are not betting on the market rising or falling. Arbitrage trading normally involves two related markets - you simultaneously buy one and sell the other. Thus your risk is restricted to the relation between the two markets.

Most commonly, arbitrage trading is between the cash market and the futures market of a given index. Suppose, for example, the cash Footsie is trading at 5,000 while a futures contract due to expire three months from now is trading at 5,050, representing a 1% premium on the cash market to reflect the cost of money.

With the cost of money at 4% p.a., this difference of 1% would be roughly fair value*.  In this case, there would be no significant arbitrage opportunity. But whenever markets rise or fall sharply the futures tend to overshoot, giving rise briefly to an arbitrage trading opportunity.  

For example, let's suppose the British government unexpectedly raises interest rates by .5%. The cash Footsie slumps in minutes by 1% to 4,950, but the futures contract, which can usually be traded faster and more cheaply than the cash contract, plummets by 2% to 4,949 - here is your arbitrage opportunity : you buy the future contract and sell the cash simultaneously, because the spread between the cash price and the future price does not represent fair value - sooner or later the cash will fall further and/or the future contract will rise, increasing the spread between the two, regardless of the average price of the two contracts.

And of course it works the other way - too wide a spread is an opportunity to bet on it narrowing sooner or later.  Generally speaking, the more liquid the market, the fewer arbitrage opportunities arise.  You can see, however, how much less risky this kind of trading is. It follows that the rewards are equally reduced.

Arbitrage trading does not need to be confined to cash versus futures: you can arbitrage virtually anything. For example, you may decide that the Dow has a bleak future, whereas the Nikkei is set to soar (I quote this one because it happens to be a fashionable belief at this moment in time).

So you can sell the Dow and simultaneously buy the Nikkei. The result will be a form of hedging that may reduce the volatility of your account balance compared to one-sided trading.

But a word of warning : different markets operate in different time zones, and when one market is closed you are fully exposed to the one-sided movement of the other. In the case of the Nikkei, for example, you'll have one-sided exposure to the Dow for about half of each 24-hour day.

Furthermore, arbitraging two different markets like this is far riskier than arbitraging a cash-futures spread, which always eventually returns to fair value - the Dow and the Nikkei could go completely the other way, actually amplifying your risk compared to one-sided trading.

*A value representing a reasonable market price - neither too high nor too low.



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