What is 'Index Arbitrage'

The index arbitrage strategy attempts to profit from the differences between actual and theoretical prices of a stock market index. This is done by simultaneously buying, or selling, a stock index futures contract while selling, or buying, the stocks in that index.

The actual component of this trading strategy is most often a futures contract with the Standard & Poor's 500 being the most popular underlying index. The S&P 500 index arbitrage is often called basis trading. The basis is the spread between the cash and futures market prices.

The theoretical price represents the prices of all the stocks in the index inputted into the specific index calculation, such as capitalization-weighted.

BREAKING DOWN 'Index Arbitrage'

Index arbitrage is at the heart of program trading, where computers monitor both actual and theoretical prices and automatically enter buy or sell orders to exploit the differences. It is a high-speed, electronic trading process. Since major financial institutions actively pursue this strategy, the opportunities are often fleeting and razor-thin. 

Big institutions can execute large trades and still make money on such small differences. The more components of the index, the greater the chances of some of them being mis-priced, and the greater the opportunities for arbitrage. Therefore, arbitrage on an index of just a few stocks is less likely to provide significant opportunities.

Traders can also use arbitrage strategies on exchange-traded funds (ETFs) in the same way. Because most ETFs do not trade as actively as major stock index futures, chances for arbitrage are plentiful. ETFs are sometimes subject to major market dislocations, even though the prices of the underlying component stocks remain stable. 

Trading activity on August, 24, 2015 offered an extreme case where a large drop in the stock market caused erratic bid and ask prices for many stocks, including ETF components. The lack of liquidity and delays to the start of trading for these stocks was problematic for the exact calculation of ETF prices. This delay created extreme gyrations and arbitrage opportunities.

The Role of Arbitrage

All markets function to bring buyers and sellers together in order to set prices. This action is known as price discovery. Arbitrage might connote unsavory dealings used to exploit the market but it actually serves to keep the market in line. For example, some bit of news creates demand for a futures contract but short-term traders overplay it. The basket of underlying stocks, the index, does not move, therefore the futures contract becomes overvalued. Arbitrageurs quickly sell the futures and buy the cash to bring their relationship back in line.

Arbitrage is not an exclusive activity of the financial markets. Retailers can also find lots of goods offered at low prices by a supplier and turn around to sell them to customers. Here, the supplier may have an overstock or loss of storage space requiring the discounted sale. However, the term arbitrage is indeed mostly associated with trading of securities and relates assets.

Fair Value

In the futures market, fair value is the equilibrium price for a futures contract. This is equal to the cash, or spot price, after taking into account compounded interest and dividends lost because the investor owns the futures contract, rather than the physical stock itself, over a specific period. So, a future contract's fair value is the amount at which the security should trade. The spread between this value, also called the basis or basis spread, is where index arbitrage comes into play.

Fair value can show the difference between the futures price and what it would cost to own all stocks in a specific index. For example, the formula for the fair value on the S&P futures contract is (Fair value = cash * {1+r(x/360)} – dividends).

  • Cash is the current S&P cash value
  • r is the current interest rate that would be paid to a broker to buy all the stocks in the S&P 500 index
  • dividends are the total dividends paid until futures contract expiration expressed in terms of points on the S&P contract
RELATED TERMS
  1. Market Arbitrage

    Market arbitrage refers to purchasing and selling the same security ...
  2. Forex Arbitrage

    Forex arbitrage is the simultaneous purchase and sale of currency ...
  3. Arbitrage Trading Program (ATP)

    An arbitrage trading program (ATP) is a computer program that ...
  4. Fixed-Income Arbitrage

    Fixed income arbitrage is an investment strategy that realizes ...
  5. Conversion Arbitrage

    An options trading strategy employed to exploit the inefficiencies ...
  6. Political Arbitrage Activity

    An arbitrage activity that involves trading securities based ...
Related Articles
  1. Trading

    Trading The Odds With Arbitrage

    Profiting from arbitrage is not only for market makers - retail traders can find opportunity in risk arbitrage.
  2. Investing

    How ETF Arbitrage Works

    ETF arbitrage brings the market price of ETFs back in line with net asset values when divergence happens. Learn how it works.
  3. Insights

    Interest Rate Arbitrage Strategy: How It Works

    Changes in interest rates can give rise to arbitrage opportunities that, while short-lived, can be very lucrative for traders who capitalize on them.
  4. Investing

    Conversion Arbitrage

    This stock/options combination helps traders take advantage of market mispricing. Find out how.
  5. Trading

    Trade Takeover Stocks With Merger Arbitrage

    This high-risk strategy attempts to profit from price discrepancies that arise during acquisitions.
  6. Trading

    Arbitrage Strategies With Binary Options

    Looking for arbitrage opportunities in Binary Options? Here are the ways to encash on those, with the opportunities, risks and limitations.
  7. Investing

    The Fast-Paced World of Libor & Fixed Income Arbitrage

    LIBOR is an essential part of implementing the swap spread arbitrage strategy for fixed income arbitrage. Here is a step-by-step explanation of how it works.
  8. Investing

    Active vs. Passive ETF Investing

    Active or passive ETF investing? Find out which one is for you.
  9. Investing

    How Mutual Fund Managers Pick Stocks

    Learn about how mutual fund managers choose stocks based on the type of funds they manage and the investment goals of the funds' shareholders.
RELATED FAQS
  1. How do I use software to make arbitrage trades?

    Understand the meaning of arbitrage trading, and learn how traders employ software programs to detect arbitrage trade opportunities. Read Answer >>
  2. What is the difference between arbitrage and hedging?

    Dive into two very important financial concepts: arbitrage and hedging. See how each of these strategies can play a role ... Read Answer >>
  3. How fair value is calculated in futures market?

    Learn how the fair value for futures stock index contracts is calculated, and understand how differences between those numbers ... Read Answer >>
  4. Why do futures' prices converge upon spot prices during the delivery month?

    Learn why as the delivery month of a futures contract approaches, the future's price will generally inch toward or even come ... Read Answer >>
Hot Definitions
  1. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  2. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  3. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
  4. Dividend

    A dividend is a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders.
  5. Inventory Turnover

    Inventory turnover is a ratio showing how many times a company has sold and replaces inventory over a period.
  6. Watchlist

    A watchlist is list of securities being monitored for potential trading or investing opportunities.
Trading Center