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What is Index Arbitrage?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 25 August 2018
  • Copyright Protected:
    2003-2018
    Conjecture Corporation
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Index arbitrage is a type of investment approach that seeks to generate a return by executing a set of transactions based on the difference between the projected future price of a stock index, and the actual price of that same index. For example, this may involve selling a stock index future while buying the stocks in that index at the same time. As with any attempt to generate this type of profit, the idea is to minimize the degree of risk involved as much as possible. For this reason, creating this type of trade can take a great deal of precision.

In order to create and execute a viable index arbitrage, the investor must develop an accurate assessment of the projected movement of the stock index futures. The idea is to allow for various factors that are highly likely to impact the futures, including those that have demonstrated significant influence in the past. Since the idea is to keep the risk as close to zero as possible, accurately projecting the price of those futures is very important. Should the prices fall short of the projections, the investor may realize little if any profit from the strategy.

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Since the process of creating a successful index arbitrage can be somewhat complicated, it is not unusual for investors to make use of product trading software to aid in identifying an option that exhibits some amount of potential for earning a return. The investor can create a profile that includes data regarding how much of a gap he or she considers viable, then set the software to monitor the stock index for any situations where that gap falls into the acceptable range. Many software packages of this type will actively monitor both the stock index and the futures contracts that are currently on the index, and alert the investor when any opportunity meeting the conditions set in place is detected. From there, the investor can evaluate the opportunity, determine if the anticipated return is acceptable given the degree of risk present, and make a decision on whether or not to execute the set of trades required.

The index arbitrage approach is more often employed by seasoned investors who understand the movement of stocks within markets, and have learned how to read the potential of futures contracts as they relate to a given security. Typically, investors who are just beginning to build a portfolio would do well to focus on less comprehensive strategies, and allow themselves time to become more educated into the various methods used to make wise investments. Only when the investor feels sure of his or her ability to identify the right stocks and execute the right combination of trades should the index arbitrage strategy be utilized.

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