Trading an Arbitrage and Reverse Arbitrage Strategy

There are two categories of traders in the stock markets.

1. Speculative :- These are the traders who simply speculate about the future price movments of a stock or the index based on their analysis , usually charts based technical analysis.Speculation can be for the increase or decrease of the future price.So positions are taken in the market accordingly, long position ( buy)  or short position ( sell)

2. Arbitragers:- These are the traders who take advantage of the price difference between the future and cash price of the same underlying.

Now what is Arbitrage and Reverse Arbitrage Strategy?

Arbitrage Strategy is technique of taking advantage of difference in the prices of Futures value and the Cash value of the same stock.You may have observed that the Futures price is usually greater than the cash price of the stock when the stock is in an uptrend.When Futures price is higher than cash price,it is called Futures are at Premium.Sometimes,the difference between these values is significantly higher which is beneficial to the arbitragers.

  Let's take an example. Assume, for any month's Futures contract,the Future price of say Infosys stock is trading at Rs 2160 and the cash price is trading at Rs 2000.Lot size for the contract is 125.Now what an arbitrager will do that he/she shall buy 125 shares of the stock in cash and simultaneously sell or short a futures contract.The logic behind the strategy is that on the expiry day of the Futures & Options contracts,the both prices will converge, that is both futures and cash prices start trading at same price.The trader will never go in loss.If stock price falls,the short position in Futures becomes profitable and if stock price rises then cash position turn profitable. So difference in Futures and cash price 2160-2000=160 has been locked and this is the profit ( 125*160=20000 ).

The point to be taken care of here is that the difference in the prices should be significant so that after excluding the transaction and commission charges for the trade, the return on the trade is appreciable ( 5-6% ).

Some modern trading softwares have inbuilt technique to identify the arbitrage opportunities.A vigilant trader can also spot the same with experience.

Reverse Arbitrage Strategy :- This is just the opposite of Arbitrage Strategy.Difference here is that you buy one lot of Futures contract and sell the same number of stocks from your demat holding.Here the Futures price is lower than the cash price.This is called Futures are at discount.

Arbitrage strategies are totally risk free source of making money in the stock market unlike speculative trading.