How to use arbitrage opportunities in commodities

By Naveen Mathur

Financial markets offer a host of trading options for investors with different risk profiles. While one can opt for various market strategies, such as trading, arbitrage and long-term investing, an interesting, low-risk option is arbitrage. It's an opportunity which can help an investor benefit from the difference in the prices of an asset on various platforms. Arbitrage helps reduce the price disparity of an asset in different markets even as it helps boost the liquidity.

There are two pre-requisites for exploiting an arbitrage opportunity. One, that the asset trades at different prices in different markets, exchanges or locations, and two, that two assets with identical cash flows should not trade at the same price. In case of commodities, too, a market participant can avail of various types of arbitrage opportunities.

Some of the major strategies that you can use in arbitrage are:
- Cash-n-carry - Spread - Inter-exchange - Inter-commodity

Here's how you can use these different types of arbitrage strategies for trading in commodities.

Cash-n-carry

Cash-n-carry arbitrage can be used between spot/physical and future prices of a commodity. This strategy is often used by commodity traders who have linkages with physical markets. In this case, arbitrageurs set up a trade in the physical market and, simultaneously, take a position in the futures market in order to gain from the price disparity between the spot and futures prices.

Suppose an arbitrageur finds that in January 2014 the price of wheat in the physical market is around Rs 1,500 per quintal. On the other hand, in the futures market, the price of wheat in February expiry contract is around Rs 1,550 per quintal. So, he can buy the commodity in the physical market and, simultaneously, sell in the futures market.

At the time of expiry, he can settle the future trade by giving the delivery of physical wheat at Rs 1,550 a quintal. In this trade, he can make a profit of Rs 50 a quintal after deducting the applicable charges.

Spread

In case of spread, arbitrageurs trade only in the futures contracts on exchanges to benefit from the price differentiation between various contracts of the same commodity. They buy a futures contract and sell another futures contract of the same underlying commodity on the exchange to profit from the price difference.

For example, the gold February 2014 contract is trading at around Rs 29,000 per 10 g and the next contract of gold April 2014 is trading at around Rs 28,500 per 10 g. Now, the arbitrageur can set up an arbitrage trade in two different scenarios. If he thinks that at the time of expiry of the February contract, the current difference of Rs 500 could reduce further, he can sell the gold February futures contract and buy the April futures contract.

At the time of expiry of the gold February contract, he can square up the trade and book a profit of Rs 500 per 10 grams. If he thinks that at the time of expiry of the February contract, the difference of Rs 500 will increase, then he can buy the gold February contract and sell the April contract. At the time of the expiry of gold February contract, he can square up the trade and book a profit of Rs 500 per 10 grams.