From the February 01, 2006 issue of Futures Magazine • Subscribe!

Understanding the arb trade

Arbitrage is one of the most influential but commonly misunderstood factors that drive price activity in modern futures markets. Understanding how arb trades work can give you an edge regardless of your trading approach.

A successful arb, in the simplest of terms, is the instantaneous, or near instantaneous, purchase of one product and the sale of another that results in a profit but a net zero position. Popularly traded products, such as the S&P 500 futures, that offer side-byside open outcry and electronic trading provide some of the best opportunities to execute arb trades today. Floor traders frequently are in position to take advantage of price discrepancies that occur regularly in the two separate marketplaces.

These regular discrepancies create arb opportunities throughout the trading day. With a basic knowledge of the simple terms and procedures used we can break down this trade, show how it affects prices, and broaden our understanding of a major influence on these markets.


MANY FACES

Arb opportunities can present themselves in many different forms. There are arb situations that occur because the market is slow and situations that are available only because the market is extremely busy and moving fast.

One arbitrage opportunity that was popular recently was the spread between cash currencies and futures. Back in the 1980s and early 1990s, banks and institutional traders would arb the interbank cash markets and the futures traded in the pit. As prices diverged, traders would buy the cash and sell the futures for instant profit. While this type of arb certainly was the predecessor to the arb of today, the two are different in many ways.

However, before we get into the specifics of modern arb trades and the influence on the markets, we need to understand the basics.

First, we have the trading pit. The trading pit is the arena where all open outcry orders are executed, or filled. The pit has three types of participants, filling brokers, locals and arb locals. Filling brokers execute trades for customers. Locals attempt to scalp the middle out of each trade by buying the bid and selling the offer. Arb locals only trade when an arb opportunity is present. Arb locals rarely hold a position for more than a second, if that long. They are in constant communication via wireless headset to another local who is sitting in front of a Globex terminal located around the perimeter of the pit.

The bid and offer are commonly misunderstood. A bid is not any buyer, and an offer is not any seller. A bid represents a buy order of a certain quantity at a certain price. An offer represents a sell order of a certain quantity at a certain price. The current bid/offer represents the narrowest spread between buyers and sellers. The difference between the bid and the offer is the spread. Trade occurs when the bid and the offer find a price within the spread they both agree upon or when a third party enters the equation and executes a trade at the standing bid or offer.

Differences in prices and tick values are necessary for the arb to occur. For instance in the S&P 500 futures, pittraded contract prices change in 0.10 increments, such as 1192.20 to 1192.30. The cash value of this change (tick) is $25.00. The E-mini contract is one-fifth the value of the pit-traded contract and it ticks in 0.25 increments such as 1192.00 to 1192.25 (see “Different ticks,” below). Even though the move is bigger, the contract value is smaller, so the cash value of this one-tick move in the E-mini is $12.50, or half the value of a one-tick move in the pit-traded contract. It's primarily contract size and tick size that create the opportunities.

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