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Easy Guide to Profiting with Cash Future Arbitrage

12 Dec 2023

In the dynamic stock or commodity market, traders always seek strategies that promise profits without significant risk. One such intriguing approach is Cash Future Arbitrage. This strategy helps you earn profit from the discrepancy between a particular asset's present and future prices. Let's get into the ins and outs of this strategy in detail.

What is Cash Future Arbitrage?

Cash future arbitrage is a chance to capitalize on the price gap between the cash (spot) and futures markets for the same underlying asset. In the cash market, you transact for immediate delivery, while the futures market involves buying or selling for a predetermined future date, known as the expiry date.

The disparity in price between the cash and futures markets is termed the basis. It may be positive or negative, influenced by the asset's demand and supply in both markets.

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Typically, the basis is positive, indicating that the futures price exceeds the cash price. This is because the futures price includes the cost of carry, which is the interest and storage cost of holding the asset till the expiry date. However, sometimes, the basis can become negative. This is called a backwardation situation, and it can happen due to high dividends, low liquidity, high volatility, or market expectations.

When the basis is negative, there is an arbitrage opportunity. You can buy the asset in the futures market, sell it in the cash market, and lock in a risk-free profit equal to the absolute value of the basis. 

How to Execute a Cash Future Arbitrage Strategy

To execute a cash future arbitrage strategy, you need to follow these steps:

  • Buy the ATM call option and sell the ATM put option of the same underlying and expiry. This is called a synthetic long futures position, replicating the payoff of buying a futures contract. The advantage of using options instead of futures is avoiding the margin requirements and the daily mark-to-market settlement of futures. The disadvantage is that you must pay the option premium, which reduces your profit margin.
  • Hedge the delta risk by buying or selling the underlying in the cash market. The delta represents the option price's responsiveness to changes in the underlying price. Since you have a synthetic long futures position, your delta is positive, meaning your option value increases when the underlying price increases. To hedge this risk, you need to sell the underlying in the cash market so that your net delta becomes zero. This way, you can eliminate the price risk and lock in the basis as your profit.
  • Hold the position until it expires or until the arbitrage opportunity disappears. If you hold the position till expiry, you can exercise the call option, sell the underlying at the futures price, and buy back the underlying at the cash price. The price difference between the two prices minus the option premium and transaction costs is your profit. If the arbitrage opportunity disappears before expiry, you can close the position by reversing the trades and booking your profit.

Factors affecting Cash Future Arbitrage strategy profitability

The profitability of the cash future arbitrage strategy depends on several factors, such as:

  • The magnitude and duration of the basis. The larger and longer the basis, the higher the profit potential.
  • The option premium and transaction costs. The lower the option premium and transaction costs, the higher the profit margin.
  • The liquidity and volatility of the underlying and the options. The higher the liquidity and volatility, the easier and faster it is to execute the trades and close the position.
  • The dividends and interest rates. The higher the dividends and interest rates, the higher the cost of carry and the lower the basis.

Conclusion

Cash future arbitrage helps you earn risk-free profit from an unusual difference between cash and futures prices in the stock market. It involves buying the ATM call option, selling the ATM put option of the same underlying and expiry, and hedging the delta risk by buying or selling the underlying in the cash market. You can find arbitrage opportunities by analysing the historical data or using a web tool and executing the strategy by following some best practices.

 

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