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What is futures arbitrage, and can I make profit using this strategy?

What is futures arbitrage, and can I make profit using this strategy?
Asked by
Benjamin Schmitz time-icon4 weeks ago
1 Answer Answer Question

Steve Walters
Answered time-icon4 weeks ago

Futures arbitrage strategies help in reaping a risk-free profit from price differentials between futures contracts and the spot price. These trading techniques bring in profit without the directional risk. If the strategy works correctly, it becomes profitable regardless of the direction of the underlying asset.

However, the downside of futures arbitrage is that the potential profit tends to be minimal after the deduction of commissions and the high capital intake because of securing positions to complete the arbitrage fully. As a result, very few amateur traders take part in arbitrage trading techniques.

 

What are the types of futures arbitrage techniques?

In futures trading, there are two main arbitrage techniques: Short the Basis and Long the Basis. These techniques require a big budget, and they are mainly for futures traders. The basis of the technique is taking positions in the futures contracts and underlying assets. In essence, these techniques generate a risk-free profit through price differentials between a futures contract and the underlying asset, which is known as the “basis” in trading futures.

Image showing an overview of futures contracts strategies meeting at a point

 

Short the Basis arbitrage technique

This technique can be used for both future arbitraging and as a spread technique for speculation on the short-term widening of the basis. This method is used when traders go short on the price differentials between a futures contract and the spot price of the underlying asset. Traders should implement this technique only when the futures price is lower than the spot price.

This means that traders can generate profits from the price differential when the futures price is notably lower than the spot price of the underlying asset. They profit by going long on the futures contract and shorting the underlying asset. Traders still make a profit, even when the futures contract expires and the prices of the underlying asset converge either upward toward the spot price or downward toward the futures price.

 

Long the Basis arbitrage technique

Long the Basis is not just an arbitrage technique; it is a spread technique for speculating on the short-term narrowing of the basis. The method is seen when traders go long on the price differentials between a futures contract and the spot price of the underlying asset. Similarly, traders employ this technique when the futures price is higher than the spot price.

Traders make profits from the price differential when the futures price is higher than the spot price of the underlying asset. Traders profit by buying the asset and then going short on its contract.

One good example is owning a product while agreeing to sell it at a higher price in the future. However, traders still make a profit from the price differentials, whether the futures price converges downward to the spot price or upward to the spot price.

 

When is the best time to implement arbitrage techniques in the futures market?

It is important to note that there will always be differentials between a futures contract and the spot price of an underlying asset that is relative to its expiry date. Also, this differential is a result of the carrying cost of holding the underlying asset. The best time for this is when the price differentials between the spot price of the underlying asset and futures contract are large enough to account for the carrying cost of holding the position and the commissions taken.

Traders using the Long the Basis arbitrage technique in the futures market need to consider the storage cost and the interest accrued in holding the underlying asset down to its expiry date. In terms of Short the Basis, traders would also have to consider the margin needs.

Professional arbitrageurs often end up being very profitable as they incur little to no commissions in trading futures. However, the reverse is true of retail futures traders as they find it tough to realise a substantial profit after accounting for commissions and carrying costs.

Chart showing a Futures Arbitrage Report

 

Pros of futures arbitrage

  • It has the potential to generate risk-free profit.
  • It maintains the market efficiency of futures contracts in the market.
  • It's a formula-driven market, and there is no need to analyse the market. Some programs automatically spot arbitrage opportunities and trade them.

 

Cons of futures arbitrage

  • The profit margin is small, unlike trading with significant capital.
  • Traders need low to no commissions to be profitable.

 

The bottom line

Traders should always test each strategy on a demo account before using any of the trading techniques mentioned above.

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