Cash-and-Carry-Arbitrage

Arbitrage is a trading strategy meant to take advantage of inefficiencies in the market.

Two similar types of investments have different prices (say, the same company trades on two different markets throughout the world and the prices are different on the different exchanges). You know that they will eventually converge (meaning the prices will move closer to each other, i.e. the inefficiency will close). So you set up a trade to take advantage of that process.

Cash-and-carry arbitrage is a particular case where this strategy comes up. In it, you arbitrage prices in the spot market (also called the cash market) and the futures market.

You notice some inefficiency between the cash and futures markets for some stock. So you buy shares of the stock in regular market and then take a short position with a futures contract for that same security.

Example.

Shares of CarryOrMiranda Inc. are trading at $50. Meanwhile, you can sell a futures contract on the stock at $52. You buy the stock at $50 and sell the futures contract for $52. You made $52 a share by selling the contract and spent $50 a share by buying the stock. You are sitting with a $2 profit per share.

Once the futures contract expires, you may be required to hand over the stock to the person who bought the futures contract. But you didn't care about the stock anyway...you were just looking to score an arbitrage profit. As long as the carrying cost of the stock is less than $2, you'll book a profit on the transaction...it doesn't matter what happens to the prices of the stock or the option during the time you hold it. You get your arbitrage profit either way.

Of course, the main problem with these arbitrage opportunities is finding them. In the modern system, where any Wall Street firm of any size depends largely on computerized trading, most inefficiencies get squeezed out of the market extremely fast. There's not much chance to slip in with a risk-free trade taking advantage of these little loopholes.