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Index Arbitrage

Futures First Academy
November 2, 2021
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Index Arbitrage

In our previous article, we explored the meaning of index futures and what buying an index and index futures means. In this article, we will explore various challenges and tools pertaining to index futures trading.

“Index arbitrage” is a popular strategy to trade index futures. It involves simultaneous buying an index and selling the corresponding index futures contract. Thankfully, selling an index futures contract is as easy as buying it. To execute an index arbitrage, a trader constantly spots the difference between an index (e.g. the S&P/TSX 60 Index*) and its corresponding futures contract (e.g. SXF). When the difference widens beyond a certain threshold, the trader will buy the index. Simultaneously, the trader will sell the number of index futures which match the monetary value of the index bought.

Note that the transaction is not complete at this stage. After the above transactions, the trader (also known as the arbitrager for such a trade) has 2 choices: –

  1. The trader can hold the position till the expiry of the index future and simply net the difference between the value of the constituents and the settlement price of the index future, or
  2. The trader can exit before the expiry of the index futures when, in the opinion of the trader, the gain is the maximum. On such a date, the trader simply reverses the original position. So, the index future is bought back and all the constituents are sold in their respective proportions.

Should the trader execute the arbitrage right after it crosses the threshold where it becomes profitable? Generally speaking, experienced arbitrageurs don’t do so. They realize that some exogenous factor has widened the difference between the index and the index futures and such factor could widen them even more. Therefore, timing an index arbitrage is a judgement call.

The fundamental basis behind index arbitrage is “value additivity”. As per this principle, the price of a series/ index should be equal to the sum of the prices of its individual constituents.

Example

In the previous article, for our example, we had considered the S&P/TSX 60 Index Standard Futures (SXF) and the S&P/TSX 60 Index Mini Futures (SXM) on the [Montréal Exchange]. Let’s continue with the same. Recall that SXF uses a multiple of C$200 times the futures contract value while SXM uses a multiple of C$50 times the futures contract value.

Let’s take the S&P/TSX 60 Index and SXM futures as an example to understand how a typical index arbitrage is executed. We know that for a retail trader, the prevailing margin rate, at the time of writing, is C$2,946 for 1 contract of SXM September 2021 futures. We also know that this futures contract’s last trading day is on 16th September 2021. Let’s assume that 30 days before the expiry, the S&P/TSX 60 Index stands at 1230 while the future trades at 1300. To execute the arbitrage, the trader buys the Index and sells 1 futures contract. For this, the trader pays the monetary value of the index that is C$61,500 (i.e. 1230*C$50) and also pays the margin of C$2,946.

On the expiry, the trader doesn’t need to deliver all the constituent shares to honor the short position in the futures. This is because the index futures are cash settled. Let’s assume that on the expiry, the futures contract and the spot index converge at 1330. In other words, on the expiry, the value of index is 1330 and the futures contract also expires at 1330. So, there’s no additional profit or loss on the expiry due to the index value and futures price being the same. From the original transaction, the trader makes a profit of 100 points (i.e. 1330 – 1230) in the index by receiving the monetary value of the index that is C$66,500 (i.e. 1330*C$50). The trader also makes a loss of 30 points (i.e. 1300 – 1330) in the futures. Overall, the trader makes a profit of 70 points (i.e. 100 points – 30 points). This is exactly equal to the original difference between the index value and the futures price i.e. 70 points (1300 – 1230). Following table summarizes the outcome of these trades.

Index Futures
Original Price 1230 1300
Expiry Price 1330 1330
Profit (Points) 100 points -30 points
Profit (Points) C$5000 – C$1500

Conclusion

Clearly, index arbitrage can sometimes result in good profits and the best part is that it’s a risk-free trade. There are two main challenges that retail traders face while dealing with index and index futures:

  1. They can’t buy each constituent of the index in its exact proportion due to their capital, and
  2. They will inevitably compete with algorithms while indulging in equity/ stock market or exchange traded futures and options.

To overcome these challenges, a retail trader has to use a robust toolkit which consists of fundamental analysis, technical analysis, quantitative analysis, etc. Additionally, several strategies can be used to make trading index futures more efficient.

Which tools and strategies a trader should use depends on the objective. Index arbitrage, as discussed in this article, is one such strategy. In our next article, we will explore more tools and strategies.

 

Disclaimer 
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2021 Bourse de Montreal Inc. All rights reserved. Do not copy, distribute, sell or modify this document without Bourse de Montreal Inc.’s prior written consent. This information is provided for information purposes only. The views, opinions and advice provided in this article reflect those of the individual author. This article is not endorsed by TMX Group or its affiliated companies. Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this article, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information. This article is not intended to provide legal, accounting, tax, investment, financial or other advice and should not be relied upon for such advice. The information provided is not an invitation to purchase securities listed on Toronto Stock Exchange, TSX Venture Exchange and/or Montreal Exchange. TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication.
Toronto Stock Exchange, TSX, TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license. SXM, SXF, Montreal Exchange and MX are the trademarks of Bourse de Montréal Inc. All other trademarks used herein are the property of their respective owners.

* The S&P/TSX 60 Index (the “Index”) is the product of S&P Dow Jones Indices LLC or its affiliates (“SPDJI”) and TSX Inc. (“TSX”). Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and TSX® is a registered trademark of TSX. SPDJI, Dow Jones, S&P, their respective affiliates and TSX do not sponsor, endorse, sell or promote any products based on the Index and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions or interruptions of the Index or any data related thereto.

Futures First provides market analysis services in various futures and options products across all asset classes, including fixed income, commodities, equity, and energy products. Futures First Academy is the educational arm of Hertshten Group, through our programs we have trained over 2000 students and are associated with more than 15+ Universities. Our goal is to provide academic solutions and educate people, in order to create opportunities and change lives. We achieve this by sharing our vast market knowledge, experience, access to live trading environments and training by industry expert educators.

Futures First Academy
Futures First Academy

Futures First Academy

Futures First provides market analysis services in various futures and options products across all asset classes, including fixed income, commodities, equity, and energy products. We operate nearly twenty-four hours a day. Our offices wake up with Japan and Australia, and close with US, Canada and Brazil. Our edge in the market comes from our highly trained professionals who can make quick and calculated decisions under pressure. We develop in-house technological tools, to analyse markets and identify opportunities by using advanced methods of pattern recognition. Our employees are passionate about using technology to enhance their working environment and hence thrive in our company.

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