Index arbitrage
Encyclopedia
Index arbitrage is a subset of statistical arbitrage
focusing on index components.
The idea is that an index (such as S&P 500
or Russell 2000
) is made up of several components (in the example, 500 large US stocks picked by S&P to represent the US market) that influence the index price in a different manner.
For instance, there are leaders (components that react first to market impact
) and laggers (the opposite). As the index is the weighted sum of all components, identifying leaders and laggers can provide a proprietary trader with the opportunity to take positions in these and make money if he/she believes the laggers will eventually rally on the leaders. The challenge being of course to correctly identify these, and to have the technology to act in the marketplace before the price correction takes place.
Other types of index arbitrage include basis trading
, the arbitrage between a current index value (synthetically replicated
) and that of its future.
Statistical arbitrage
In the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
focusing on index components.
The idea is that an index (such as S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
or Russell 2000
Russell 2000
The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index.The Russell 2000 is by far the most common benchmarkfor mutual funds that identify themselves as "small-cap",...
) is made up of several components (in the example, 500 large US stocks picked by S&P to represent the US market) that influence the index price in a different manner.
For instance, there are leaders (components that react first to market impact
Market impact
In financial markets, market impact is the effect that a market participant has when it buys or sells an asset. It is the extent to which the buying or selling moves the price against the buyer or seller, i.e. upward when buying and downward when selling...
) and laggers (the opposite). As the index is the weighted sum of all components, identifying leaders and laggers can provide a proprietary trader with the opportunity to take positions in these and make money if he/she believes the laggers will eventually rally on the leaders. The challenge being of course to correctly identify these, and to have the technology to act in the marketplace before the price correction takes place.
Other types of index arbitrage include basis trading
Basis trading
Basis trading is a trading strategy usually consisting of the purchase of a particular security and the sale of a similar security ....
, the arbitrage between a current index value (synthetically replicated
Synthetic replication
Synthetic replication is the process by which a financial asset's payoff is exactly replicated by trading other securities.For instance Black Scholes theory claims vanilla option pricing can be achieved through the use of stock and zero-coupon bond....
) and that of its future.
See also
- Algorithmic tradingAlgorithmic tradingIn electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
- Complex event processingComplex Event ProcessingComplex event processing consists of processing many events happening across all the layers of an organization, identifying the most meaningful events within the event cloud, analyzing their impact, and taking subsequent action in real time....
- Dark pools of liquidity
- Statistical arbitrageStatistical arbitrageIn the world of finance and investments, statistical arbitrage is used in two related but distinct ways:* In academic literature, "statistical arbitrage" is opposed to arbitrage. In deterministic arbitrage, a sure profit can be obtained from being long some securities and short others...
- Electronic tradingElectronic tradingElectronic trading, sometimes called etrading, is a method of trading securities , foreign exchange or financial derivatives electronically...
- Implementation shortfallImplementation shortfallIn financial markets, Implementation Shortfall is the difference between the decision price and the final execution price for a trade. This is also known as the "slippage"...
- Investment strategyInvestment strategyIn finance, an investment strategy is a set of rules, behaviors or procedures, designed to guide an investor's selection of an investment portfolio...
- Quantitative trading