It is common for an asset to be available in various markets at various prices. These differences in prices can occur due to supply and demand figures or inefficient pricing. These price differences create what is known as an “arbitrage opportunity”, meaning it provides a way for you to accumulate returns by selling and buying assets in various markets and at differing prices.
While dealing with financial markets, you might choose to apply different trading strategies. The common ones include long-term investment, arbitrage, or even purchase and sale. The strategy that you choose might depend on your tenure, the capacity of investments, financial objectives, or risk tolerance. In an unstable market, it becomes possible to trade with minimum risks and good returns when using an arbitrage strategy.
Keep reading to gain an understanding of arbitrage trading along with its strategies:
What Is Arbitrage Trading?
Arbitrage is a term that refers to selling and buying assets to generate profits from price differences relating to an asset in various markets. These are assets that could be a currency, security, or commodity that you can buy and sell across markets simultaneously. Arbitrage assists with improving market liquidity and efficiency for trading. Arbitrage funds share a few similarities with equity funds and are also made available to investors that are interested in investing in the arbitrage of shares and securities.
Arbitrage Trading with Commodities
In most cases, commodities require transportation and storage space to ensure they are available around the world. They are also traded in various forms across different markets. In most cases, there are differences in the prices of one commodity in futures and spot markets and across exchanges.
These price differences are what create arbitrage opportunities where the commodity can be sold or purchased in various markets at differing rates. The goal of this involves generating returns with no or minimal risk for investors. Individuals that can identify arbitrage opportunities across different markets and are also involved in trading commodities are known as arbitrageurs.
We have added a lot of useful information to this article, but this is an in-depth topic. If you would like to learn more about this, you may want to visit a site like USA Futures which is dedicated to teaching investors how to trade commodity futures in a safe manner.
What to Look for in an Arbitrage Opportunity:
Below are some green lights to look for an arbitrage opportunity to be present:
• The asset in question has prices that vary across the various markets.
• Two assets that have similar cash flows have to trade at prices that are different.
• The asset must have different current and future trading prices.
Let’s now take a closer look at some of the arbitrage methods you can choose when you trade in commodities.
Cash And Transport Arbitrage
The Cash and Transport method is aimed at taking advantage of inefficiencies in prices for a specific asset price action in the futures and spot market to accumulate profits without risks. The arbitrageur will purchase a long position with the commodity and then at the same time sell a position using a futures contract with this same asset. The investor will carry the asset to the date the contract expires and deliver it according to the futures contract. Sometimes this is referred to as a basic exchange.
For example, if an asset is currently trading at Rs 100 with the added cost of Rs 6 as the carrying cost. At the same time, the same asset is available in a futures contract at Rs 105. On finding this opportunity, the arbitrageur invests using the cash-and-transport strategy to secure a profit which in this case would be Rs 4.
This strategy can only be profitable when the inflow of cash on selling according to the futures contract has exceeded the carrying cost and acquisition of this asset. At the same time, this is a strategy that is not nearly risk-free. The added carrying costs might in some cases increase, and that will reduce your profit margin.
With this strategy, arbitrageurs take advantage of price differences that occur between the same commodity or asset but between 2 future contracts. This strategy involves buying futures contracts for an asset or commodity and then selling them as per a different futures contract that can accumulate profits. Other trades, known as spreads, tend to be lower in risks and less volatile in trading when compared to other strategies such as normal futures trading.
Here is an example, if a commodity X April 2020 contract is currently trading at Rs 600 per unit, yet another contract for this same commodity X July 2020 trades at Rs 540 per unit. The investor can now decide when the April 2020 contract expires whether he/she wants to sell the April futures contract along with buying the July futures contract. This will usually depend on the way the arbitrageur predicts future prices.
This is another popular method that can assist you with arbitrage commodity trades. With this method, arbitrageurs exploit the difference in prices for one commodity for the contract that expires at the same time but on other exchanges. These differences in prices across the exchanges are what create arbitrage opportunities. When one commodity has differences in prices it mainly occurs due to instability, specifications of a contract, or liquidity.
Here’s an example, if ABC April 2020 futures contract is currently trading at Rs 600 per unit on one of the exchanges but is trading at Rs 450 per unit on another exchange, the investor can make profits of Rs 250 per unit.
Lower Risk Commodity Trading
Because arbitrageurs sell and buy commodities at prices that differ from what they know about in the different markets, the risks are less. The only problem with commodities, which is rare but it does happen, is that in some cases there are extra costs linked with maintenance and storage until sold. In some cases, this can slightly affect the profit margins.
Even though the risks are limited, it is still a good idea to gain a thorough knowledge of the markets that relate to a commodity that you are interested in. You should be focused on taking maximum advantage when it comes to price differences by making sure you exploit suitable trading strategies.