Index arbitrage seems very simple...am I missing something?
For simplicity, when we have long position of a stock, we look at its constituent index, if the index futures is trading at the premium of its fair value we sell, and vice versa.
There doesn't seem any kind of human intervention in trading strategies, as long as we come up with good measure to price the FV of the futures well, and have reasonable latency then all we do is just compare with fv and market value and sell/buy.
The traders out there, in IBs, Props...some say their job is index arbitrage. (I don't think it's like index rebalancing strat..that would be a more complex job in whole different level as it's more of a quant job)
What am I missing here? could anyone provide any insights on how traders here develop some genuine trading strategy?
Instances of true arbitrage where you can simultaneously execute in the future and the basket of stocks with the desired weights would be very rare. There is going to be a lot of complexity in managing and executing these positions. Having offsetting large futures/stock positions on your balance sheet is also capital intensive and will require managing your capital usage.
The opportunities you mentioned essentially do not exist. The actual opportunities are way more subtle than this and are basically only edge cases that are not discussed in academic papers or online. There are a few cases where it probably does work, but you have to keep in mind most of the time you’ll be missing something and it’s more likely your model is wrong. An interesting question to consider is “what are possible cases where someone would demand the ETF far more than the constituents or what are situations where the simple arb relationship would break down or have some hair on it?”
A simple example, what happens to your arb if ETF trades in US but some of constituents do not? In this case the arb is more complex and involves a bit more art. There are 100 other cases like this, but you won’t think about them unless you look at this stuff every day.
Everything in trading seems simple until you actually do it ;)
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