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Definition
The investing term index arbitrage refers to a trading strategy that takes advantage of the difference between the futures price of an index and its cash price. Program traders can take advantage of these anomalies by buying or selling the index future, while simultaneously assuming the opposite position for the stocks that make up the index.
Explanation
Index arbitrage is typically accomplished using program trading techniques. Computer systems are instructed to monitor the difference between the spot price of a stock index (such as the S&P 500) and its futures contracts. When the difference between a futures contract and its corresponding cash price moves through pre-programmed thresholds, simultaneous buy and sell orders will be placed for stocks, index futures, or exchange traded funds (ETF).
The difference between a futures contract and its spot price is referred to as basis or spread. Generally, there are sets of rules which index arbitrage follows:
If a futures contract is deemed high relative to the cash price of the index, the index future is sold and the stocks making up the index are purchased.
If a futures contract is deemed low relative to the cash price of the index, the index future is purchased and the stocks making up the index are sold.
In either of the above scenarios, the arbitrageur is fully hedged against upward or downward movement in the value of the index. Profits are made when the spread between the futures contract and its spot price returns to its "normal" or expected value.
Example
In this example the futures price is deemed high relative to the cash price of the index, so simultaneous orders are placed to sell (short) the futures contract and buy the index. This position is now fully hedged against movements in the index itself. If the index goes up, the value of the cash position increases, while the value of the futures contract decreases by the same amount. If the index goes down, the value of the cash position decreases, while the value of the futures contract increases by the same amount.
If the difference between the futures contract and the spot price narrows, the arbitrageur will profit from their short position in the futures contract.
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