Equity, Index, Options and ETF Arbitrage

ar•bi•trage (är b -träzh ) n. - The nearly simultaneous purchase and sale of securities or foreign exchange in different markets in order to profit from price discrepancies.

In the case of ETFs, there are arbitrage opportunities, but unless you are an institutional investor, you probably won’t get the chance to take advantage. However, it is important to understand how arbitrage helps keep ETF prices in line with their correlating indexes and the equities in the fund. ETF assets and related indexes are indicators of an ETF’s performance and should move in unison. If not, there is chaos.

An Example

As a simple example, let’s use an ETF that is made up of four equities. Each equity trades at $25, and the actual ETF trades at $100. The ETF tracks an index that consists of the same four equities, but two shares of each stock are in the index. Therefore the index is trading at $200. Everything is in balance and so far so good.

If the underlying equities move up, so should the ETF and the index in direct correlation. And vice versa if the equities are down. But what happens when the equities move faster than the ETF and the index?

Let’s say that the equities drop $5 each and now trade at $20. Therefore, the index should trade at $160, and the ETF should trade at $80, right? However, there may be the case where the ETF or index lags and could possibly trade at $81 or $161. Not everything moves in unison. Uh oh.

The Role of Arbitragers

That’s when the arbitragers step in. Before you can blink, they are selling the overpriced index and ETF and buying the underlying equities to capture that extra risk-free dollar. Eventually (and rather quickly), the arbitrage trades push the equities, indexes, and ETFs back in line so that all three investments are once again in balance. And the arbitrage opportunity is gone (and short-lived).

While this is an extreme example, statistics have shown that most arbitrage situations are closer to pennies than dollars, the trading volume does make it worth an arbitrager's while. But more important, arbitrage trades play an important role in the world of ETFs. They keep your investments correctly priced at least according to the market.

So that is how arbitrage works, but as I mentioned above, unless you are an institutional trader (or really on your game), most of these rare instances will be gone too fast for you to capitalize. And they are pennies on the dollar, so you would need to do it on a large scale. But the concept is important to understand. 

A Word of Caution

And while ETFs may be attractive, be sure to conduct thorough research before making any trades. Check the history of the ETF, understand the risks, watch the fund in action, and see how it reacts to different market conditions. Also, take a look at what is in the funds as many ETFs may contain derivatives such as futures and options. And if you have any questions or concerns, be sure to consult a financial professional, such as a broker or advisor.

However, once you are comfortable with ETFs, then it’s only matter of calling your broker (unless you trade online). And once you do make your choice, then good luck with all of your trades.