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Equity, Index, Options and ETF Arbitrage

How Arbitrage Works in the World of ETFs

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ar•bi•trage (är b -träzh ) n. - The purchase of securities on one market for immediate resale on another market in order to profit from a price discrepancy.

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.

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

So if the underlying equities move up, so should the ETF and the index. 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. However, there may be the case where the ETF or index lag and could possibly trade at $81 or $161. That’s when the arbitragers step in. Before you can blink, they are selling the overpriced index and ETF and buying the underlying equities in order to capture that extra risk-free dollar. The arbitrage trades push the equities, indexes, and ETFs back in line so that all three investments are once again in balance.

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.

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