Index Arbitrage

Index Arbitrage is a trading strategy that involves taking advantage of price discrepancies between an index and its underlying components or related derivatives. This strategy aims to profit from inefficiencies in the pricing of these financial instruments.

Understanding Index Arbitrage

Definition

Index Arbitrage occurs when a trader simultaneously buys and sells index-related securities (such as futures contracts or ETFs) to profit from differences in pricing. The fundamental principle is based on the relationship between the index and the prices of its constituent stocks.

How Index Arbitrage Works

– Price Discrepancy: Traders monitor the prices of an index and its components. If the index’s price does not accurately reflect the underlying assets, this creates an arbitrage opportunity.
– Simultaneous Transactions: To exploit the discrepancy, traders execute simultaneous buy and sell orders. For instance, they might buy the undervalued asset and short-sell the overvalued one.
– Market Efficiency: The activity of arbitrageurs helps to correct price inefficiencies, which contributes to market efficiency.

Calculation of Profit from Index Arbitrage

To calculate profits, consider the following scenario:

1. Index and Futures Correlation: Assume the S&P 500 Index is trading at 4,000 points, while the S&P 500 futures contract is priced at 4,020 points.
2. Arbitrage Opportunity: A trader notices that the futures are overvalued compared to the index.
3. Execution:
– The trader sells short 1 futures contract at 4,020 points.
– Simultaneously, the trader buys the equivalent amount of stocks in the index proportionally.
4. Price Adjustment: After some time, the futures price decreases to 4,000, aligning with the index price.
5. Closing the positions:
– The trader buys back the futures contract at 4,000 points.
– The profits are calculated as:
– Short Sale Price: 4,020
– Buy-back Price: 4,000
– Profit = Short Sale Price – Buy-back Price = 4,020 – 4,000 = 20 points.
6. Total Profit: The profit per contract must be multiplied by the contract size to determine total profit.

Example of Index Arbitrage in Action

Imagine a situation where a trader identifies an arbitrage opportunity involving the S&P 500 and the SPDR S&P 500 ETF Trust (SPY).

1. Scenario:
– The S&P 500 Index is at 3,900.
– SPY is trading at $390.

2. Identifying the Discrepancy: Due to market fluctuations, SPY should theoretically be closer to the index price (1:1 ratio). However, say SPY is selling at a discount.

3. Execution:
– The trader buys 100 shares of SPY at $390 per share (total investment = $39,000).
– Simultaneously, the trader shorts the equivalent index futures.

4. Price Convergence: After a short period, SPY rises to $395 as the market corrects itself to align the ETF price with the index.

5. Closing the positions:
– Selling SPY at $395 means the trader receives 100 x $395 = $39,500.
– The trader then closes the short futures contract at a profit.

6. Profit Calculation: The profit from this arbitrage transaction would be:
– Total from selling SPY: $39,500
– Total spent on buying SPY: $39,000
– Profit = $39,500 – $39,000 = $500.

This example demonstrates how traders can uncover and exploit pricing discrepancies through Index Arbitrage, contributing to improved market efficiency while potentially yielding significant profits.