Index Arbitrage as a Day Trading Strategy - dummies

Index Arbitrage as a Day Trading Strategy

If you have decided to add arbitrage to your bag of day trading strategies, consider index arbitrage. Arbitrageurs love an asset — like an index — that has lots of different securities based on its value because it creates lots of opportunities for mispricing. Unless the index, the futures, the options, and the exchange-traded funds are all in line, some canny day trader can step in and make some money.

Market observers talk a lot about the performance of the S&P 500 Index and the Dow Jones Industrial Average. These market indexes represent the activity of the market and are widely published for market observers to follow.

The performance of the index is based on the performance of a group of securities, ranging from the 3,000 largest companies in the market (the Russell 3,000) to a mere 30 large companies (the Dow Jones Industrial Average).

Sure, an arbitrageur could buy all the stocks, and some hedge funds do just that. But very few people can afford to pursue that strategy. Instead, they get exposure to index performance through the many different securities based on the indexes.

Buy-and-hold mutual fund investors can buy funds that hold all the same stocks in the same proportion as the index. Those with shorter-term profits in mind can buy exchange-traded funds, which are baskets of stocks listed on organized exchanges, or they can trade futures and options on the indexes.

Suppose, for example, that the S&P 500 futures contract is looking mighty cheap relative to the price of the S&P 500 Index. A trader can short an exchange-traded fund on the index and then buy futures contracts to profit from the difference.