What Is an Arbitrage
In Forex and CFD trading, an arbitrage means the simultaneous purchase and sale of an asset with the goal of making profit from a difference in the asset’s price between two markets. An arbitrage opportunity in most cases would arise as a result of the mispricing of an instrument from a certain online broker. This in turn creates incentives for a trader to buy or sell the asset, depending on whether the price is higher or lower compared to the market and, at exactly the same time, making an offsetting trade with another brokerage, where the quote is correct.
It usually does not take long until the mispricing company realizes its fault and fixes it. Once this is done, the time is ripe for both positions to be closed at the prevailing market price. Please, note that the trader is indifferent whether the market has moved up or down for the time he had open positions: he will be at a loss in one of the accounts and at a profit in the other one. The latter, however, will be higher compared to the incurred loss. The positive result for a trader will be the initial difference in the quotes of the two brokerages, minus the bid-ask spread.
Why Index Arbitrage
Arbitrage opportunities could arise in virtually every asset class. Most commonly though they are present in spot index trading. This is why the current article is focused exactly on this asset class.
The reason for arbitrages occurring more often in indices is rather simple: dividends. The pricing of these instruments comes from the futures market. An index futures has all dividends and interest till the end of its maturity calculated and accounted for in the price of the futures from the very first day of its launching. However, this is not the case with spot indices, whose price needs to be adjusted each day when a stock from the corresponding benchmark distributes a dividend. This should be done prior to market open on the ex-dividend date. Latency in doing that results in mispricing and hence, creates an arbitrage opportunity.
Some Risks and Specifics You Need to Be Aware Of
- Do Not Trade In Big Sizes – arbitrage hunting is a low-risk trading strategy, yet not a completely risk-free one. The main hazard is your trade being reversed from one of the brokers. As you might expect, the party to do that would probably be the one where you made money, which would result in your balance being set to its state before the transaction. In this way you would be left with the loss you suffered in the other account and nothing to compensate for it. You cannot do much to change the situation even if you complain, as you have traded at an incorrect price, which according to a trading company’s terms of business is a breach.
- Choose Liquid Markets – trading the most liquid European, UK and US indices will guarantee you that in most cases you will be able to close your positions at a favorable price. On the contrary, if you make an arbitrage on a market characterized by low liquidity, you run the risk of encountering problems when you want to close your trades. The issues that you might have include but are not limited to the following: market halts due to lack of trading activity, big differences between the bid and the ask prices, substantial slippage, etc.
- Beware Of the Spreads – the difference between the bid and the ask price should be considered as a type of commission charged by an online broker on each trade you make. The wider the spread of an instrument in one or both of the platforms, the lower the potential profit of the arbitrage. With this in mind, choose instruments with tighter spreads not just for this but for any strategy.