Understanding Cash-Future Arbitrage in Stock Markets

Traders use cash-future arbitrage to profit from price differences between the cash (spot) market and the futures market. This strategy, also called cash and carry arbitrage, plays a vital role in maintaining price equilibrium between related markets. It is favoured for its relatively low risk profile when executed properly.

In stock markets, arbitrage is a key strategy for professional traders, institutional investors, and market makers. The strategy is beneficial if you seek to capitalise on minor mispricing without taking significant market risk. 

At its core, arbitrage is the simultaneous purchase and sale of an asset in different markets to profit from price discrepancies. Arbitrage can take various forms, such as spatial, statistical, or merger arbitrage. Cash-future arbitrage bridges the spot market and the derivatives market.

It refers to the strategy of exploiting the price difference between the stock's spot price and futures price. This difference arises due to factors like the cost of carry, interest rates, dividends, and time until the contract’s expiration.

You can buy the underpriced asset in the cash market and simultaneously sell it in the futures market. It locks in a risk-free or low-risk profit as the prices converge. 

Key Components:

• Cash Market (or Spot Market): This is where actual securities are bought and sold for immediate delivery

• Futures Market: Where contracts are bought and sold to buy or sell securities at a future date at a predetermined price

Cash-future arbitrage involves taking advantage of price differences between markets. As the futures contract nears expiry, the price convergence allows you to profit from the price gap.

Step-by-Step Process

Here is the stepwise process through which you can benefit from the arbitrage strategy: 

1. Identify Price Discrepancy: Spot a gap between the stock’s price in the cash market and its futures price, known as the basis. The basis = Futures Price – Spot Price 

2. For Simultaneous Trades:

• Buy shares in the cash market 

• Sell an equivalent futures contract of the same stock

3. Hold Until Expiration or Price Convergence: Hold both positions until the futures contract expires or the price difference narrows.

4. Close Positions:

• Sell the shares in the cash market

• Buy back the futures contract 

• The profit is the difference in price minus transaction costs, margin requirements, and any borrowing costs

Example:

Say Stock A trades at ₹1,000 in the cash market and its 1-month futures contract is priced at ₹1,020. The arbitrageur buys shares at ₹1,000 (cash market) and then sells futures at ₹1,020.
Until expiry, the futures price can converge to ₹1,005, and the stock price can remain close to ₹1,000. If this happens, the arbitrageur profits from the initial price gap (adjusted for costs).

Arbitrage opportunities arise when the futures price deviates from the theoretical fair value, which is derived from the cash price and the cost of carry. Factors influencing this include:

• Dividends and Interest Rates: Higher rates increase the cost of holding positions. It can reduce the price gap and limit profits. 

• Duration of Basis: Greater and longer-lasting price differences offer higher profit potential.

• High Liquidity and Volatility: High trading activity and price movement make it easy to enter and exit positions. 

• Low Transaction and Option Costs: Lower costs increase the profit margin by reducing expenses.

Cash-future arbitrage offers low-risk profit opportunities to you as an investor. However, it also comes with challenges such as timing risk, transaction costs, and margin requirements

Advantages

• Low-Risk Strategy: When executed correctly, arbitrage minimises market risk since simultaneous buy and sell positions hedge each other

• Market Efficiency: Arbitrageurs help in narrowing price differences, improving overall market efficiency

• Profit in Any Market Direction: Arbitrage profits rely on price convergence, not market direction, which allows potential gains in bullish or bearish conditions

Limitations

• Transaction Costs: Brokerage fees, taxes, and bid-ask spreads can reduce profitability

• Margin Requirements: Futures trading requires margin, tying up capital

• Timing Risk: Price convergence may not occur as expected within the contract period

• Regulatory Constraints: Compliance with the Securities and Exchange Board of India (SEBI) and exchange rules is mandatory, limiting certain practices

1. Cash-Future Arbitrage in the Indian Stock Market

In India’s stock market structure, cash-future arbitrage is a popular strategy. It leverages price differences in instruments like Nifty, Bank Nifty, and large-cap stocks under SEBI’s framework. 

As per regulations set down by SEBI, intraday trading is allowed. However, for delivery-based arbitrage, you need to hold the shares in your Demat account. You cannot buy and sell shares on the same day under this strategy without taking delivery. 

So, you must sell the shares you already own at the higher price and buy back the shares at a lower price for gains. In India, you can also participate in this strategy via arbitrage mutual funds. 

2. Market Structure

India’s stock market is divided into cash and derivatives segments. Both NSE and BSE offer futures trading on selected stocks and indices. 

• Cash Segment: Immediate delivery of shares

• Futures Segment: Contract for future delivery at a price agreed when purchasing

3. Regulatory Framework

SEBI governs trading practices, ensuring fairness and transparency. SEBI enforces delivery-based rules that prevent same-day cross-exchange stock transactions without actual delivery. 

4. Arbitrage Taxation in India

Arbitrage funds in India are classified as equity mutual funds for taxation purposes. 

• Gains from units sold within 12 months are treated as Short-Term Capital Gains (STCG). They are taxed at a flat rate of 29%. 

• Gains from units held for over 12 months qualify as Long-Term Capital Gains (LTCG). Returns from LTCG above ₹1 Lakh in a financial year are taxed at 10% without indexation. 

• Many funds implement an effective LTCG tax rate of approximately 12.5%. 

5. Tools and Platforms for Arbitrage Trading

Popular brokerage apps offer tools for spotting price differences across markets. For more sophistication, algorithmic trading tools enable you to automate arbitrage opportunities. This is something often not accessible to retail traders.

Cash-future arbitrage remains a vital mechanism in stock markets. It contributes to price discovery and market efficiency. While it offers low risk, it requires precise execution, awareness of costs, and regulatory compliance to be successful.

This content is for educational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.