Arbitrage strategies involve buying a lower priced asset in one market and selling the same asset at a higher price in another market. In derivatives (F&O segment), this typically involves shorting an overpriced futures contract and going long on the underlying stock in multiples of the permitted lot size. We have discussed this strategy previously in this column. But arbitrage opportunities fade fast, as traders exploit such price differences. This week, we discuss how you can arbitrage between futures and spot prices based on your opportunity cost, allowing for more frequent arbitrage set-ups.
Price convergence
There are two elements to spot-futures arbitrage trade based on the opportunity cost principle. First, you must identify a futures contract that is overpriced in relation to your opportunity cost. This is a simple process. Look at the return you are currently earning on the cash that is part of your trading capital. This cash could be earning interest in a savings account or return on an overnight fund, a mutual fund that invests in securities with overnight maturity. Next, determine the fair value of the futures contract. This involves plugging three inputs into the standard futures valuation model: the spot price of the underlying, the time to expiry of the underlying and the return you currently earn on the capital that will be used in the arbitrage trade (the opportunity cost). Note that the return is an annual rate. The model converts this to a period rate – the return applicable for the days remaining till expiry of the futures contract. Once you have determined the fair value of the futures, compare it with the actual futures price. If the actual price is greater than the fair value, the futures is considered overvalued. Then, there is a potential to short.
The second element is the number of shares you must have in your demat account. This must match with the permitted lot size. This is important because an arbitrage trade must not have market exposure. Matching the number of shares with the permitted lot size of the futures contract ensures a hedged position. Such a position will lock in to the gains amounting to the difference between the spot price and the futures price at the time of initiating the trade. This is possible because of the price convergence factor: i.e., futures price converges with the spot price at expiry.
Optional reading
Arbitrage trades offer near-pure alpha returns, as market risk is near-zero. The strategy requires sizable capital, as shares must be bought to match the permitted lot size. Note that the opportunity cost principle is easier to apply if you have tactical cash in your trading capital: cash that you are intentionally holding to initiate a trading position at the most opportune time. The opportunity cost accounts for the returns you give up by locking capital in the permitted lot which is the number of shares that you must buy in providing initial and mark-to-market margins on the short futures position.
(The author offers training programmes for individuals to manage their personal finance)
Published on October 11, 2025