Arbitrage Trading: Pros and Cons

     Arbitrage trading has small risks and stable returns. For large funds, if unilateral heavy positions intervene, they will face higher holding costs and greater risks. On the contrary, if unilateral light positions intervene, although risks may be reduced, the opportunity cost is, Time cost is also higher. Therefore, it is difficult to obtain a relatively stable and ideal return for large funds unilaterally heavy warehouses, or unilaterally weak warehouses to intervene in the futures market as a whole.

     However, if large funds intervene in the futures market with long and short two-way positions, that is, carrying out arbitrage transactions, that is, not only can they avoid the risks faced by unilateral positions but also may obtain relatively stable returns. Now, let's take a look at the advantage of doing an arbitrage trading.

Advantages of 

Arbitrage Trading

• Lower volatility. 

     Since arbitrage trading obtains the return of the spread of different contracts, and a significant advantage of the spread is that it usually has lower volatility, so the arbitrageur faces less risk. Generally speaking, the volatility of the spread than the volatility of the future much smaller price. For example, the Shanghai Futures Exchange on the copper daily price change generally 400-700 Yuan (or CN¥)/ton, but the price difference between adjacent delivery months is about 80-100 CN¥/ton. 

     Many commodity prices are highly volatile and require daily monitoring. The intra-day fluctuation of the spread is often small, and it only needs to be monitored a few times a day or even less. If the funds in an account fluctuate severely, speculators must deposit more money to prevent possible losses. With arbitrage trading, there are few such concerns.

• Limited risks 

     Arbitrage trading is the only futures trading method with limited risk. Due to the existence of arbitrage and the competitive choice among arbitrageurs, price deviations between futures contracts will be corrected. Taking into account the transaction cost of arbitrage, the spread between futures contracts will remain within a reasonable range, so there are not many cases where the spread exceeds this range. This means that you can establish arbitrage positions in historical high or low areas based on historical statistics of spreads, and at the same time, you can estimate the level of risk to be assumed.

• Lower risk. 

     Because of the hedging characteristics of arbitrage trading, it usually has a lower risk than unilateral trading. This is an important factor that we need to consider when comparing arbitrage and unilateral trading. "Why is the risk lower?", you asked. Well, portfolio theory shows that a portfolio consisting of two completely negatively correlated assets minimizes portfolio risk. Arbitrage is the simultaneous buying and selling of two highly correlated futures contracts, that is, a portfolio consisting of two almost completely negatively correlated assets is constructed, and the risk of the portfolio is naturally greatly reduced.

• Protection of price limit. 

     The hedging characteristics of many arbitrage transactions can protect price limits. Because of political events, weather, government reports, etc., futures prices can rise and fall sharply, sometimes even causing price limits, and prices are blocked on the price limit and cannot be traded. A unilateral trader who does the opposite will lose a lot before he can close his position. This often results in a shortfall in the trader's account, and is required to do margin call. 

     In the same environment, arbitrage traders are protected. Taking intertemporal arbitrage as an example, because an arbitrage trader is both long and short on the same commodity, his account usually does not suffer a large loss on the limit day. Although the price difference may not go in the direction predicted by the trader after the price limit is opened, the loss caused by this is often much smaller than that of unilateral trading.

• More attractive risk/return ratio. 

     Relative to a given unilateral position, an arbitrage position can provide a more attractive risk/return ratio. Although the profit of each arbitrage transaction is not very high, the success rate is high, which is the benefit of the limited risk, lower risk, and lower volatility characteristics of the spread. In the long run, only a small number of profitable unilateral transactions are made, and often no more than 3 out of 10 are profitable. Arbitrage is different. It has the characteristics of stable return and low risk, so it has a more attractive return/risk ratio, which is more suitable for the operation of large funds. In the fierce competition between longs and shorts who hold unilateral positions, arbitrageurs can often intervene at the opportunity to make profits easily.

• Spreads are easier to predict than prices. 

     The price of futures is often not easy to predict due to its large volatility. In a bull market, futures prices will rise unexpectedly high, and in a bear market, futures prices will fall unexpectedly low. Arbitrage trading does not directly predict the future price changes of futures contracts but predicts changes in the price difference caused by changes in future supply and demand. The latter kind of prediction is much less difficult than the former one. It is very complicated to determine the supply and demand relationship that affects commodity prices in the future. Although there are rules to follow, it still contains many uncertainties. 

     To predict changes in the spread, you do not have to consider all factors that affect the relationship between supply and demand. Due to the relevance of the two futures contracts, many uncertain supply and demand relationships will only cause the prices of the two contracts to rise and fall at the same time, which has little effect on the spread, and this type of supply and demand relationship can be ignored. Predicting the change in the spread between two contracts only needs to pay attention to the difference in the response of each contract to the same change in supply and demand. This difference determines the direction and magnitude of the change in the spread.

     After talking about the advantages of arbitrage trading, how you could have your risks lowered and limited, easier to predict spreads, having more risk/return ratio, and not to mention lower volatility, now, let's move to the disadvantage that could happen when doing arbitrage trading, shall we?

Disadvantages of 

Arbitrage Trading

• Potential benefits are limited. 

     In the eyes of many investors, the biggest disadvantage of arbitrage is that the potential gains are limited. This is normal. When you limit the risk in trading, you will usually also limit your potential returns. However, whether to choose arbitrage trading, in the end, has to be weighed against the many advantages of arbitrage and the limited potential benefits, as one would say, "Low risk, low reward".

• Excellent arbitrage opportunities rarely appear frequently. 

     The number of arbitrage opportunities is closely related to the effectiveness of the market. The lower the market efficiency, the more arbitrage opportunities; the higher the market efficiency, the fewer arbitrage opportunities. 

     As far as the current domestic futures market is concerned, the degree of effectiveness is not high, and there are several good arbitrage opportunities for various futures products every year. However, compared to the unilateral megatrend, there are more arbitrage opportunities every year.

• The price deviation continuing to be wrong. 

     The strong-weak relationship between contracts tends to maintain a situation of "the strong will always be strong, and the weak will always be weak" in the short term. If this price deviation will eventually be corrected, arbitrageurs will also have to suffer temporary losses in such transactions. 

     IF investors can withstand such losses, they will eventually turn losses into profits, but sometimes investors cannot survive the loss period. Moreover, if the short-selling contract encounters a short-squeeze phenomenon and continues until the contract is delivered, the price deviation will not be corrected, and the arbitrage transaction must fail.