It occurs by capitalizing the price difference in three instances –
- Futures and Spot Market
- Two contracts in Futures Price.
- Speculation on co-integrated commodities.
Let’s discuss the three major strategies that occur in the Indian Market.
1. Cash and Carry – Its called pure or deterministic arbitrage –
It’s used when there is a price disparity between futures and spot market of a particular commodity. Consider a commodity trader buys a bag of soybeans from the market at 500 INR. We must assume a holding cost for 6 months lets say, 50 INR.
Holding cost = Storage cost + Risk-Free Rate
Now if the trader manages to short the futures at 600 with an expiration of the contract being 6 months in future, he can deliver the stored commodity and earn a risk-free profit of (600-500-50) = 50.
This is called a cash and carry arbitrage.
The trader carries the commodity into future and cashes out via the futures contract.
Reverse cash and carry are also possible.
2. Future Calendar/Times/Horizontal Spread –
It involves simultaneous purchase and sale of futures contracts on the same underlying asset expiring on different dates. Its modeled to profit from the difference in the rate of movement of prices between near term and far term futures contracts.
It involves long on the short-term future contract and short on the far-term future contract.
- Buy NIFTY May Futures.
- Sell NIFTY July Futures.
It is an apt example of Bull Spread.
It involves short on the short-term future contract and long on the far-term future contract.
- Sell NIFTY May Futures.
- Buy NIFTY July Futures.
Advantages of these spreads –
- POP is high – Probability of Profit is higher than a naked futures trade.
- Lower Margin – Broker gives immense margin benefit to initiating this kind of trades. So % wise the returns are great.
- Volatility – Its a market neutral position due to the counter movement of the futures contract involved.
3. Inter-Commodity Arbitrage –
Considering different commodities on the same exchange having the same cash flow or in the same category, there is a possibility of creating an inter-commodity arbitrage. It’s pure speculation. Arbitrager long one contract and short another the other contract to make a profit.
Hindalco moves with the price of Aluminum; it doesn’t fall under this kind of arbitrage but is a notable example of correlation.
Doing a recap, Spotting a deterministic arbitrage opportunity in commodities –
- Speculating two co-integrated commodities based on market condition and historical data.
- The price difference between two futures contracts of a near and far term of the same commodity.
- The price difference between the futures and spot market for the same commodity.