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
  1. Forex Arbitrage

    Forex arbitrage is the simultaneous purchase and sale of currency ...
  2. Market Arbitrage

    Market arbitrage refers to purchasing and selling the same security ...
  3. Arbitrage Trading Program (ATP)

    An arbitrage trading program (ATP) is a computer program that ...
  4. Statistical Arbitrage

    Statistical arbitrage is a profit situation arising from pricing ...
  5. Outward Arbitrage

    Outward arbitrage is a form of arbitrage whereby banks borrow ...
  6. Telecom Arbitrage

    Telecom arbitrage is a strategy providing long-distance access ...
Related Articles
  1. Investing

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  2. Investing

    How Precious Metals Like Gold Can Be Arbitraged

    Arbitrage trading involves a lot of risk and can get challenging. Find out how to benefit from the price differential between the buy and sell price.
  3. 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.
  4. Investing

    How Statistical Arbitrage Can Lead to Big Profits

    Statistical arbitrage is one of the most influential trading strategies ever devised. Learn how it is leveraged by investors and traders seeking profits.
  5. Trading

    Using index futures to predict the future

    Want to know whether the stock market will open up or down? Learn about index futures and how they can help predict how the market will trade.
  6. Investing

    3 Mutual Funds Focusing on Arbitrage Profits (MERFX, ARBFX)

    Get details on three of the most popular mutual funds for investors interested in arbitrage trading.
  7. Tech

    Looking for Bitcoin Arbitrage Opportunities? Read This First

    Bitcoin arbitrage involves buying relatively undervalued bitcoins and selling them at exchanges where they are relatively overvalued in order to make a profit.
  8. Small Business

    How To Profit From Mergers And Acquisitions Through Arbitrage

    Making a windfall from a stock that attracts a takeover bid is an alluring proposition. But be warned – benefiting from m&a is easier said than done.
  9. 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.
  1. How do I use the news to find arbitrage opportunities?

    Learn what risk arbitrage trading is and how this type of opportunity is available to individual retail investors. Read Answer >>
  2. How do I use an arbitrage strategy in forex trading?

    See how forex arbitrage acts upon opportunities presented by pricing inefficiencies through the buying and selling of different ... Read Answer >>
  3. 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 spot price will generally inch toward or even ... Read Answer >>
  4. Is it Possible to Invest in an Index?

    While you cannot buy indexes, which are just benchmarks, we'll show you three ways for you to mirror their performance. Read Answer >>
  5. Why are futures contracts important?

    Learn about social and economic functions of futures contracts and the futures market, and discover why speculators help ... Read Answer >>
Trading Center