Index Arbitrage Explained: Profiting from Price Discrepancies

Index arbitrage is the systematic process of trading the spot market and the futures market in such a way that captures the difference between the two prices.

Index arbitrage occurs on a daily basis by professional traders. In the early morning hours of trading at the opening bell the futures market price and spot price will be out of whack due to the volatile nature of early morning and overnight trading in the futures markets.

Normally, what happens is before the opening bell, if the market is expected to go up the futures market will be well above the spot market price. With that said, the index arbitrage that normally takes place is the selling of the futures price and buying the spot price for the short term balancing of the two markets.

For longer term trades, the trader will normally buy the futures market and sell the spot market, when in a bull market trend. The opposite is true for a bear market trend as well, sell the futures market and buy the spot market. Eventually, as the two markets converge, at time of futures expiration dates, the discrepancy between the two prices will be realized as profit.