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Concepts & Tutorials

Arbitrage funds are risky?

Are arbitrage mutual funds really risk free? PersonalFn attempts to debunk that theory saying:

  • Buy-stock, sell-future is the common arbitrage used. Futures are usually priced higher than stocks. Yet, in a bear market, futures are priced at less than spot prices so arbitrage cannot be used.
  • Slippage in prices can result in bad execution. The author takes an example of a stock-future combo arbitraged at 100-105. The 5 rupee assumed profit is actually not that much because on the expiry day, when you unwind the deal, you may have a spot-future price of 106-108, meaning the real profit is only Rs. 3.
  • When no arbitrage opportunity exists, some funds can buy pure stocks (‘naked’) which introduces risk.
  • Low liquidity can cause problems because there may be enough buyers and sellers.

Before you go any further, if you want to know what futures and options are, read my Introduction to Futures and Options article. Arbitrage funds essentially buy in the cash market, and sell in the futures market at a higher price and lock in the profit.

I think they are right to a certain extent. Arbitrage funds have a certain embedded risk in them but then so do fixed deposits beyond Rs. 1 lakh. The bank can go kaput, and that is just about as likely as some of the scenarios mentioned above.

While there may be slippage (difference between exercised and executed prices) you will find that the slippage factor is usually accounted for in India where you get between 1 to 1.5% as arbitrage on an opportunity.

Secondly, arbitrage can be zero risk if it’s classic arbitrage. You can’t provide “assured” returns, but you can guarantee zero risk in that if you buy a stock and sell it’s future you can lock in gains, unless you choose a ridiculously illiquid stock on the futures market. In the last thirty minutes of trade on expiry day nearly every single (liquid) stock converges within 0.1% of its future! So slippage on unwinding is very small compared to the actual arbitrage, and if you’re worried about such small amounts you should be worried about bid/ask spreads and commissions as well. (again, small enough to hurt your net return, but will not generally introduce “risk”, i.e. a way for you to LOSE your capital).

Note here that risk simply means the potential erosion of your capital. Not a potential erosion of your returns. Arb funds don’t guarantee returns, but they can do a zero risk deal.

Remember that funds needn’t even sell owned stocks to square off. They can re-sell the next month future if the arbitrage opportunity exists, that way they save brokerage and any potential slippage thereabout.

For instance, if an arb fund had decided on the RCOM stock. When the stock is increasing in price, there has been increasing hedging opportunity on the stock (the arbitrage spread has been increasing). So if you bought on April 26 at 474 and sold the 31-May future at 477, you would make Rs. 3 per contract. On May 31, the May 31 contract closed at 505.45. The fund can sell the RCOM stock bought and square off the loss on the future (of Rs. 28.45 per share).

But the June 28 contract was selling at 512, a Rs. 6.5 premium (more than 1% for a month). So instead of selling stock, the fund can take the loss on the future, hold the stock, and sell the June-28 future again. This can be continued as long as a) there are no redemptions and b) the arbitrage opportunity still exists. Of course, as the stock keeps going higher there will be losses on the future (which are equal to unbooked gains on the stock), but that can be adjusted by selling just enough stocks to make up that loss. Again, zero risk in reality (even if the price came down).

Yet there can be a larger risk than you think, also. Some arbs (like JM Arbitrage fund) take into consideration things like dividend arbitrage (buying a stock post dividend assuming the market will take the stock back to its pre-div price) and acquisition arbitrage (buying a stock that is being acquired and therefore has an open offer at a higher price) These are inherently more risky than classic arbitrage and that introduces a portfolio risk for you.

Can you and I take advantage of arbitrage? The answer is yes. But we have to be quick on our feet and execute two trades simultaneously. Plus, we have to ensure that on the trade expiry day we either roll over our positions or square off, either of which must be done or you expose yourself to needless risk. And lastly, our commissions on our brokerage must not wipe out our gains. For instance, if I used my Sharekhan account (0.5% brokerage each way on a sell and buy of stock, 0.1% each way on the future) I would not make any returns because the typical arbitrage is about 1% a month.

But I could use my Reliance Money account, which gives me a very very low brokerage (Typical round trip brokerage for a single contract is about 0.1% all sides included). Which means I could earn 0.9% a month if I went down the arbitrage route.

Note: what follows can look like an advertisement for my new venture. It might be. I am very excited about it so please excuse me if you find it weird.

Yet, arbitrage needs me to know which opportunities to use, and how to use them effectively. And to know when the spreads are in your favour and when not. That requires time and effort which I know is difficult for the regular investor – so here is where I bring in my new company. My new company, Moneyoga.com, will address that situation by providing you feedback on such opportunities (arbitrage, how to execute, when to sell etc.) – and the best part is, most of it will be free.

And we won’t stop at arbitrage – there are a lot more opportunities we can use by just understanding how the market works. We intend to create a map for you that will help you lower your risk by automatically alerting you when there are signs of negative or positive action on your stocks, and by telling you about how you can protect your portfolio, use income generating strategies or identify new stocks, futures or options you can leverage.

It’s under construction and will take some time to develop. Meanwhile I’ll keep posting our findings here.

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  • Anonymous says:

    >Hi, Deepak
    Being an MBA and working in consulting firm I am still unable to understand these future & options. I think it will be very usefull for all ppl who want trade on future and options and but dont know the concept……may be your easy-understanding writting style may help them out. It is good that you are starting company which will focus on all these issues( tel me if your company is limited co, I will subscribe some shares, may be I can make money in IPO ;))

  • Deepak says:

    >Hey deepak,

    That is a good idea, since you are also looking at a network of investors, maybe you should also link up with one of the active investor communities like midas and link up on the investor grievance part also. It will serve a good platform.

    All the best for the new venture, if you in Bangalore and have a couple of hours some weekend, we should catchup

    Deepak nadiger

  • Deepak Shenoy says:

    >Anon: I’ve written an introduction to futures and options on this blog earlier. I will link it in the article as well.

    And yes, my company is a private limited company. At this point we’re so new (two weeks) that it would be premature for anyone to subscribe. Let’s get a prototype out and see how it goes.

    Deepak: Yes, we should catch up in Bangalore. I’m as free as free gets, with the caveat that I stay up till 3 AM programming 🙂 Shall link up on mail. Btw, what’s the link to Midas? Can’t seem to find it on google…

  • Rohit Chauhan says:

    >Hi deepak
    best wishes on your new venture. hope to learn about options / futures trading from your new venture
    regards
    rohit

  • Deepak says:

    >Deepak,

    Midas does not have a web address, but they have setup another setup to help investors. I had blogged about it here http://business-samhita.blogspot.com/2007/06/investor-grievance-redressal.html

    It actually helps, I had a unpaid amount from Lloyds finance, approached them thru Midas and got it back in 15 days.

    Pass the word around

    Deepak Nadiger