Index Arbitrage

A stock index is meant to track a basket of stocks. The S&P 500 is a famous one. It tracks a group of 500 of the largest and most influential U.S. stocks, making it the benchmark indicator for equity performance. Ask someone "how did Wall Street do today?" and they'll likely tell you how much the S&P 500 moved.

While it represents a high-profile case study, the S&P 500 is just one example. There are hundreds of stock indexes, each targeting different baskets of stocks. Some follow general market performance (the S&P 500, the Dow Jones Industrial Average). Others target specific industries or particular market cap sizes (small cap, mid cap, etc.).

These indexes are fundamentally mathematical constructions. We say they track "baskets of stocks," but it's not like there's an actual basket somewhere. As such, there can be some space between the theoretical performance of stocks in an index and the performance of the actual stocks that underlie that index.

Index arbitrage looks to profit from these potential gaps in performance. An investor would buy (or short) a futures contract based on a particular index, and then take the opposite position in the actual stocks that make up that index. The theory is that, over time, the little mispricings that happen in the index system will work themselves out. The gap will close. When it does, the arbitrage position will squeeze out some profit.