Introduction

Arbitrage involves buying an asset in one market and selling it in another. You are attempting to take advantage of discrepancies in price across markets. By purchasing an asset in one market and selling it in another at the same time, you help to equalise prices across marketplaces, contributing to the efficiency of each market. An approach to arbitrage in derivatives is to obtain a position in the spot market, then get a position in a futures contract, which is an agreement to buy/sell to take delivery for an asset, at a predetermined price, on a predetermined future date. To use these strategies, you first need access to the spot and futures platforms and ways to buy and sell the securities. Second, you need enough margins and access to borrow money, all done within India's regulatory environment.

What is Cash and Carry Arbitrage?

In cash and carry arbitrage, you take advantage of a situation where the futures price of an asset is greater than the spot price, plus the costs of holding the asset until the futures contract expires (known as contango). You could buy the asset in the spot market and sell a futures contract for the same quantity of assets. Holding costs, such as storage costs for physical commodities, interest on borrowed capital, and trade commissions, must be counted. When the futures contract expires, you let go of the asset to fulfil the contract, earning the difference between the higher futures price and your holding costs.

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This strategy can be effective when you have an ample supply but expect the supply to decrease, which will inflate future prices. In India, you might apply this to crude oil or spices, where seasonality impacts price. Just ensure the futures premium allows you to hold the physical asset, and there is no cost to make the trade worthwhile. The trade is low risk because you will execute your short and long positions against each other; however, keep an eye on unexpected increases in storage costs related to asset holding. It means accepting changes that could dig into your profits for your trade.

Are you considering Reverse Cash and Carry Arbitrage?

Given the name Reverse Cash and Carry Arbitrage, you would use this strategy when the futures price is lower than the spot price, and backwardation is caused primarily by immediate demand or spikes in supply pushing up the supply. Following this, this is how you would shorten this asset in the spot market (borrowing it first to sell now and repay later) and then taking a futures contract at the lower price. The placement of the asset itself may release the same positive from the time value of money in the amount generated from your short as you can invest in any safe asset available (such as government securities or fixed deposits) until your expiry date and make a return on it. At expiry, you take delivery via the futures to cover your short position.

When dealing with stocks, you must account for borrowing costs, margins for shorting, and any dividends or yields. Backwardation typically happens in metals during global supply disruptions or equities during corporate-specific events in India. In a strong backwardation scenario, traders could make money on situations where the spot-futures discount exceeds their costs, which puts an 'almost' risk-free profit on the table. The trader in registers should make sure their lenders approve of shorting and understand India's strict margin costs.

A Real-World Example of Reverse Cash and Carry

Let's assume we are trading silver (a common asset on Indian exchanges). Suppose the spot price is ₹80,000 per kilogram, and one-month futures trade at ₹78,000. Your estimated costs of shorting and carrying (total interest on borrowed funds and lagging time-based interest) are ₹1,200. You then short one kilogram in the spot market, and obtain the ₹80,000, which you invest in a short-term debt fund where you won't earn interest. Simultaneously, you would buy a futures contract. At expiry, you will buy silver at ₹78,000 via futures and use it to close your short position. Profit is equal to the selling price less the purchase price less the expenses: ₹80,000 - ₹78,000- ₹1,200 = ₹800. This example shows how you can take advantage of inefficiencies in the market.

Conclusion

If you want to leverage cash-and-carry or reverse cash-and-carry arbitrage, you should start executing small trades on demo accounts to familiarise yourself with the markets. We also recommend speaking with a financial expert to ensure this makes sense for your risk profile. The trading ecosystem in India is constantly evolving. If you can effectively implement cash-and-carry and reverse cash-and-carry arbitrage into your repertoire, you can take advantage of any arbitrage attractiveness and do it with confidence.

Similar Reads: What is Arbitrage Trading and how does it work? | Making sense of Arbitrage: various types | Can I do an arbitrage trade between two exchanges? | Spot market vs Futures market