Arbitrage is a term used to describe the simultaneous purchase and sale of an asset to profit from price differences between different markets. In futures trading, arbitrage opportunities can arise when there are slight variations in the price of certain assets or commodities on different exchanges. By taking advantage of these price discrepancies, traders can generate profits through arbitrage strategies.
The three types of arbitrage strategies
The three types of arbitrage strategies used in futures trading are:
Index arbitrage- involves purchasing an index futures contract and then selling a corresponding basket of stock and bond indexes to profit from price discrepancies between the two market.
Commodity arbitrage- In this strategy, traders buy low-priced commodities and sell them at a higher price in another market to generate profits.
Currency arbitrage- is the practice of taking advantage of differences in currency exchange rates to generate profits by buying an asset cheaply in one country and selling it at a higher price elsewhere.
Whether you’re just starting as a futures trader or are looking for new ways to maximise your profitability, understanding these different types of arbitrage strategies can help you make more informed decisions about your trades.
If you’re interested in exploring the many different arbitrage strategies available in futures trading, consider collaborating with an experienced broker or financial advisor who can help guide your decision-making process. With the proper knowledge and tools at your disposal, it is possible to consistently take advantage of these profitable opportunities and maximise your returns over time.
How to execute an arbitrage trade
While you can use many different arbitrage strategies to generate profits from futures trading, executing an arbitrage trade is relatively straightforward.
Identify an opportunity – The first step in any successful arbitrage strategy involves identifying any price discrepancies between markets and taking advantage of these opportunities when they arise. It often involves closely monitoring prices on both local and international exchanges for slight fluctuations or inconsistencies.
Execute orders – Once you’ve identified a potential arbitrage trade, you will need to place two separate orders: one to purchase the asset at its current price and another to sell it at a higher price elsewhere. Depending on the type of arbitrage strategy involved, this may require buying assets in several different markets and selling them all at once to generate a profit.
Close out the trade – Once you’ve executed your arbitrage orders and generated a profit, it’s time to close out the trade and lock in your gains. It usually involves selling off the assets you purchased at their current prices and using the proceeds to offset any losses from the initial sale. With proper planning and execution, arbitrage trades can effectively boost your profitability from future trading activities.
Pros and cons of arbitrage trading
Like any trading strategy, arbitrage strategies for futures come with their own set of pros and cons. Some of the main benefits to consider include:
The ability to generate consistent profits – You can generate regular earnings from your arbitrage trades over time by taking advantage of minor price discrepancies between markets.
Reduced risk exposure – Because you are simultaneously buying and selling assets in different markets, there is generally less risk involved in an arbitrage trade than in other types of futures trading. It’s also important to be aware of some potential risks of using arbitrage strategies in your trading activities.
Risks may include:
Higher commissions – Since you will need to place multiple orders when executing an arbitrage trade, you may incur higher commission costs than other futures trading types.
Increased time requirements – To correctly identify and execute arbitrage opportunities, you will need to spend more time tracking prices and market conditions daily.
Examples of successful arbitrage trades
The London Gold Fixing
In 2012, a group of banks was accused of manipulating the London Gold Fixing; a vital benchmark used to price gold contracts on futures exchanges worldwide. By artificially inflating or deflating prices during the daily fix, these banks could take advantage of minor discrepancies in the prices of gold contracts and generate significant profits for themselves.
The VIX ‘Flash Crash’
In February 2018, a sudden plunge in the Chicago Board Options Exchange’s Volatility Index (VIX) caused a brief flash crash in the U.S. stock market. While many investors lost money during this event, some savvy traders were able to take advantage of the opportunity by executing arbitrage trades on futures contracts based on the VIX.
If you would like to participate in arbitrage trading, you can find more information at Saxo.