What Is Spot-Futures Arbitrage Trading?

Updated: Oct 25, 2019



Spot-futures arbitrage, also known as cash-and-carry-arbitrage, is an established strategy which aims to capitalize on the price difference between a spot market and a futures contract. Derived from the family of market-neutral strategies, the main advantage of spot-futures arbitrage is the low risk associated. The only requirement for this strategy to be profitable is that funds invested in a short futures position exceed the purchase cost and carrying costs on the long position of the underlying asset.


Market-Neutrality

All market-neutral strategies aim to profit from both the increasing and decreasing prices in one or more markets. They can be either dollar-neutral or beta-neutral. For instance, market-neutral traders may take a 50% long and 50% short position simultaneously in a particular market. The reason for this is that their focus lies on making calculated bets on pricing discrepancies, as the main goal is achieving a zero beta portfolio - a portfolio constructed to have zero systematic risk.


Historically, the market has registered two types of market-neutral strategies: fundamental arbitrage and statistical arbitrage. The former is based on fundamental analysis as traders use this type of analysis to predict future prices of a specific financial instrument or an asset. On the other hand, statistical arbitrage leans more towards technical analysis as it uses algorithms and different statistical methods from historical data to predict future price discrepancies in assets.


The Basis

As the name itself says, spot-futures arbitrage is focused on two different markets: spot and futures markets. In spot market trading, all trades are instantly settled, unlike in futures trading, where the agreed contract obliges a seller to sell the asset to a buyer at an agreed-upon price and on the agreed-upon date.


The difference between the spot price and the agreed-upon future price is where the focus of spot-futures arbitrage lies. Especially during increased market volatility, the spot market prices tend to deviate by some margin from the futures prices. The difference between the two prices is called the basis. Logically, the higher the basis, the better the trading opportunity, and vice versa.


Theoretically, futures contracts with later expiration dates tend to hold more uncertainty as there is more time for price fluctuations; hence the basis is usually higher. Futures with later expiration dates also tend to be more expensive compared to the price of the underlying asset. As the time passes by, the basis decreases until it becomes or gets very close to zero at expiration.


The basis convergence is guaranteed by the final settlement of the futures contract, which often settles to a particular spot market price. Furthermore, due to the basic law of supply and demand, buying an underlying asset on a spot market increases the demand for the asset itself. On the other hand, shorting futures contracts is likely to cause a drop in futures prices as it creates an increase in the supply of contracts available for trade. The same situation applies when the spot market prices are higher than the futures, except that in this case traders are selling asset on the spot market and purchasing the futures contracts.


With that being said, as spot-futures arbitrage traders continue to execute this strategy, the spot and future prices converge as the expiration date gets closer. Traders closely monitor the basis to see whether it is higher than the trade costs (spread, commissions, fees, etc.). For this reason, the majority of arbitrageurs trade opportunities arise from highly liquid financial instruments in the first place.


Conclusion

Spot-futures arbitrage is a classic and simple trading strategy, characterized by low risk and its simplicity. In essence, traders monitor the basis - the difference between the spot market price and the futures price of the underlying asset - and engage in a trade if the basis is greater than the trade costs. The basis convergence is almost guaranteed to happen at the expiration date of the futures contract due to the final settlement price mechanism.

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