Index Arbitrage

What Is Index Arbitrage?

Index arbitrage is a trading strategy that attempts to profit from the price differences between two or more market indexes. This can be done in any number of ways, depending on where the price discrepancy originates. It may be arbitrage between the same index traded on two different exchanges, or it may be arbitrage between two indexes that have a standard relative value that has temporarily diverged from its standard. It can also be arbitrage between the instruments that track the index (e.g. index ETFs or options), and the components that make up the index.

Understanding Index Arbitrage

The strategy of index arbitrage is executed by buying the relatively lower-priced security and selling the higher-priced security with an expectation that the two prices will eventually match again (or be equal).

Index arbitrage is at the heart of program trading, where computers monitor millisecond-changes between various securities and automatically enter buy or sell orders to exploit the differences that (theoretically) shouldn't exist. It is a high-speed, electronic trading process that is more often pursued by major financial institutions because the opportunities are often fleeting and razor-thin.

The Role of Arbitrage in Markets

All markets function to bring buyers and sellers together 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, if news creates demand for a futures contract, but short-term traders overplay it, then 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 overstock or loss of storage space requiring the discounted sale. However, the term "arbitrage" is mostly associated with the trading of securities and relates assets.

Index 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.

A future contract's fair value is the amount at which the security should trade. The spread between this value—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)

Where:

• 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.

Examples of Index Arbitrage

The S&P 500

One of the more well-known examples of this trading strategy includes attempting to capture the difference between where the S&P 500 futures are trading and the published prices of the S&P 500 Index itself. The S&P 500 Index arbitrage is often called basis trading. The basis is the spread between cash and futures market prices.

The theoretical price of this index should be accurate when totaled as a capitalization-weighted calculation of all 500 stocks in the index. Any difference between that number, in real-time, and the futures trading price, should represent an opportunity. If the components were cheaper, then executing a buy order on all 500 stocks instantaneously and selling the equivalent amount of higher-priced futures contracts should yield a risk-free transaction.

Naturally, such a strategy would take significant capital, high-speed trading, and little to no commissions or other costs. Given these factors, such a strategy is more likely to be profitable when executed by large-scale banking and brokerage operations. Such institutions can execute large trades and still make money on very small differences. The more components of the index, the greater the chances of some of them being mispriced, and the greater the opportunities for arbitrage. Therefore, arbitrage on an index of just a few stocks is less likely to provide significant opportunities.

Exchange-Traded Funds

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 Aug. 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.