What is index arbitrage?
Index arbitrage is an investment strategy designed to profit from the differences between the actual price of a stock and the theoretical futures price of the same stock. When successful, it can make a profit by exploiting market inefficiencies, which occur when the current price doesn’t reflect the most recent information about the stock.
To help identify inefficiencies, investors can use program trading techniques to monitor a stock index and any futures contracts on it. If a difference is spotted they can execute orders automatically, simultaneously buying or selling the stock or future.
Where have you heard about index arbitrage?
Index arbitrage can sometimes be called basis trading. You may have heard it mentioned in conjunction with “day trading” strategies, which is the process of buying and selling a security within a single trading day.
What you need to know about index arbitrage.
If you’re an individual investor you may find it difficult to make a profit from index arbitrage as:
- The window to benefit from an index arbitrage opportunity is small
- Sophisticated computers and systems are required for program trading
- Transaction costs can be high, as the strategy requires simultaneous buying and selling
While index arbitrage may provide attractive opportunities that are considered to be relatively low risk, loss can still occur.