An Introduction to Futures Arbitrage

Futures arbitrage is the process of leveraging the price differential between an underlying asset and the asset’s futures contract. Every derivative product built around an underlying asset has the potential to occasionally exhibit mispricing. Traders can identify mispricing and take advantage of the discrepancy by using tools and procedures.

Table of Contents:

What Is Futures Arbitrage

Leveraging price differences across marketplaces is known as arbitrage in trading. Futures arbitrage is an opportunity to leverage the differential between the cash price and the futures contract, especially at the beginning of the month. The term “basis” refers to this discrepancy between the cash and future price. Both the future and spot values are comparable as the expiration date draws near. However, there is a price differential in the run-up to the expiration date, or during the arbitrage period. An asset’s negative basis indicates that future price increases are anticipated for the asset. A positive basis portends a potential bear run as it implies that the current or cash price is greater than the projected price.

This trading strategy necessitates monitoring the basis carefully to see whether it exceeds your transaction cost. In theory, a futures contract with a much later expiration date can be more uncertain because there is a greater possibility of price swings. These futures may cost more than the underlying asset. The basis decreases with time until it approaches or equals zero, at which point the expiry date occurs.

Important Considerations When Trading Futures Arbitrage

Contango is the word used when the futures trade at a premium (higher) than the spot or cash market. Whereas contango is more frequently utilized in the commodities futures market, the premium is mostly utilized in the equity derivatives market.
“Backwardation” is the term used to describe a futures trade at a discount, or lower, than the cash market. Although this phrase and discount have similar meanings, backwardation is a term that is frequently used in the commodities derivatives market.
A growing discount is indicative of a downward trend in the market.
A rising premium indicates that a bull market is likely to occur soon.

Example of Futures Arbitrage

Take a look at stock X on January 1, 2020. It is priced at Rs 150 in the cash market and Rs 152 in May futures. Assume that the contract’s multiplier is 100 shares. Assume that there is a cost of carry, equivalent to an interest rate of 8% annually or 0.75% monthly. The formula F = S*exp(r/T), where “S” is the spot price, “r” is the cost of carry in percentage, and “T” is the remaining time for expiry in years, is used to determine the fair price in such an instance. Therefore, 150*exp (0.0075*5/12) is the fair price, giving us a result of 150.469. This indicates that the futures contract is overpriced (the market price is Rs 152). As a result, you short futures and long cash.

A trader holding 100 shares of this stock would benefit by Rs 500 (155-150×100), should the stock price rise to Rs 155. The futures will cost you between Rs. 155 and Rs. 152×100, or 300. Thus, the trader receives Rs 200 from the arbitrage. This arbitrage has a cost of Rs 0.469, or Rs 46.9 for 100 shares. The total benefit for you will be Rs 200 – Rs 46.9. That comes to 153.1 rupees.

Conversely, if you suppose that stock X falls to Rs 148 from Rs 150. The loss on the underlying asset in this case would be Rs 200 (for 100 shares). For 100 shares, the futures profit would be about Rs 400 (152-148). The profit from the arbitrage would be Rs 200. Eliminating the carry cost would require you to take out Rs 46.9 from the Rs 200, leaving you with Rs 153.1. This cash futures arbitrage example demonstrates how the trading method is inherently straightforward.

Conclusion

Futures provide traders a relatively risk-free way to profit on pricing disparities by leveraging them, as demonstrated by the above futures arbitrage example.