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Futures Arbitrage - Definition
Futures trading strategies designed to reap a risk free profit through the difference in prices between futures and spot price.
Futures Arbitrage - Introduction
Arbitrage using futures is one of the three most important functions of futures trading. There are three main types of market participants in the futures market and they are; Hedgers, Speculators and Arbitrageurs. Arbitrageurs practise futures arbitrage techniques in order to reap risk free profits from the futures market. The problem with futures arbitrage is that the potential profit may be very little after taking commissions and bid ask spreads into consideration while typically demanding very high capital outlay in order to secure positions in the underlying asset in order to complete the futures arbitrage. As such, futures arbitrage is a field which very few amateur futures traders can participate in.
What is Futures Arbitrage?
Arbitrage has been talked about in futures trading since its very beginning, so what does arbitrage mean?
Futures arbitrage, are risk-free arbitrage techniques which returns a profit without any directional risk. This means that if the arbitrage technique is applied properly, you will make a profit no matter which way the underlying asset moves. Arbitrage has existed for as long as the capital market has and futures arbitrage is a way of taking advantage of the pricing difference between the underlying asset and the price of their futures contracts. In fact, every derivative instrument created on the same underlying asset gets slightly mispriced from time to time and arbitrageurs have sophisticated programs to detect and take advantage of such minor discrepancies in price.
In fact, the pricing relationship between an asset and its derivative instruments are kept fair by the actions of these arbitraguers, without whom, the price of derivatives would be grossly seperated from the reality of its underlying asset. Everytime a mispricing occurs, arbitraguers come in to close it up (and reaping a small risk-free profit as a result) before it gets any worse, thereby creating a fair and effective derivatives market. This is also why futures arbitrage is important in keeping futures prices connected with the reality of their underlying assets.
Types of Futures Arbitrage Techniques
There are two main futures arbitrage techniques; Long The Basis and Short The Basis. Both techniques require taking a position in the underlying asset as well as its futures contracts, as such, these are techniques possible only for futures traders with a significantly big fund. Both futures arbitrage techniques involve making a risk free profit through the price difference between the underlying asset and its futures contracts, which is known as the "Basis" in futures trading.
Futures Arbitrage - Long The Basis
Long the Basis isn't only a futures arbitrage technique when held all the way to expiration, but also a futures spread technique for speculation on a short term narrowing of the basis. Being long the basis means being long the price difference between the spot price of the underlying asset and its futures contract. This is possible when the futures price is significantly higher than the spot price.
When the price of the futures price is higher than the spot price of the underlying asset, you can reap that price difference as profit risk free by buying the underlying asset and then going short on its futures contract. This technique is particularly useful in normal markets. This is the same as owning a product and then simultaneously going into agreement to sell it at a higher price in future. When the futures contract expires, the price of the underlying asset would converge with the futures price, and no matter if the spot price converge upwards towards the futures price or the futures price converge downwards towards the spot price, you will still make that price difference in profit.
Learn more about Long The Basis.
Futures Arbitrage - Short The Basis
Short the Basis isn't only a futures arbitrage technique when held all the way to expiration, but also a futures spread technique for speculation on a short term widening of the basis. Being short the basis means being short the price difference between the spot price of the underlying asset and its futures contract. This is possible when the futures price is significantly lower than the spot price.
When the price of the futures price is lower than the spot price of the underlying asset, you can reap that price difference as profit risk free by shorting the underlying asset and then going long on its futures contract. When the futures contract expires, the price of the underlying asset would converge with the futures price, and no matter if the spot price converge downwards towards the futures price or the futures price converge upwards towards the spot price, you will still make that price difference in profit.
Learn more about Short The Basis.
When Is It Profitable To Perform Futures Arbitrage?
There will always be a difference between the spot price of an asset and its futures contract with significant time to expiration. This price difference is primarily due to the carrying cost of holding the underlying asset. As such, futures arbitrage is profitable only when the price difference between the futures contract and the spot price of the underlying asset is big enough to justify the carrying cost of holding the position and the round trip commissions involved. In the case of being Long The Basis, the storage costs and the interest foregone in holding the underlying asset all the way to the expiration of the futures contract needs to be considered and in the case of being Short the Basis, interest on margin needs to be considered as well.
In most cases, futures arbitrage is only really profitable for professional arbitrageurs or market makers who incurs almost no commissions in their futures trading. Most retail futures traders would find that the basis is so small in a liquid futures market that you really don't make any profit after considering commissions and carrying costs.
Advantages of Futures Arbitrage
:: Maintains proper pricing of futures contracts in the market
:: Capable of reaping risk free profit
:: Formula driven so no market analysis is needed. Softwares are programmed to automatically spot and trade futures arbitrage.
Disadvantages of Futures Arbitrage
:: Very small profit margin
:: Requires very big capital outlay
:: Requires low to no commissions account to be profitable