Using technology for Arbitrage

Technology has had significant impact on human race in almost every sphere of life. So why not use the impact of same on trading. I discussed in brief about using technology for trading purposes in my last article on Algorithmic trading. Continuing on the same lines, I now want to tell you in very simple words how algorithms can be used in arbitrage which is the bread and butter of almost all traders across the world.

What do I mean by Arbitrage

It is a kind of trading where traders earn profits by exploiting price difference of similar or identical financial products on different market or in different forms and this Arbitrage exists because of market inefficiencies.

Example: – A program can buy or sell the future stock of a commodity like gold depending upon the spread level of same product of different expiry month contract in the Indian commodity market (MCX).

Let us take the October and December contract of gold. Since current month for gold is October, under all normal circumstances, we will have more liquidity in the October contract and comparatively December contract does not have such liquidity. So in the spread trading, when we say buying a spread, it would typically mean we are buying the October contract and selling the same quantity of December contract and the price difference of gold between two contracts is known as the spread. Similarly, with sell spread we sell the current contract i.e October contract and buy the December contract. As a normal trading rule, our aim is to buy the spread at low levels and sell at high levels or vice versa. For instance-

If we are of the view that this difference will increase, i.e in absolute terms, the spread between October and December contract will decrease, so we will sell the spread at current levels. We go short on October contract and go long on December contract. After 5 days, the prices increase as follows-

Thus we make a gain of Rs 34 on gold spread. It needs to be mentioned here that this spread has equal chances of decreasing as well in which case we would have lost money on the strategy. The key in arbitrage lies in executing the buy/ sell spreads at required levels with very less impact cost. This is where technology comes into play.

How technology/algorithms can help in carrying on arbitrage

Algorithmic trading refers to automated trades executed through software programs, which do not require humans to place orders every time. There are computer programs written to buy or sell a security, currency or commodity at a given or predefined level. These programs are so fast that people, who look at various developments and decide trade, would be left way behind because a machine has done it in milliseconds. So it has become extremely difficult to earn profit for the manual traders. The future belongs to traders with superior technology in case of arbitrage business. The National Stock Exchange (NSE), which controls more than three fourths of the trading volumes, has approved applications of 200 of its members, roughly a fourth, to trade using algorithms.

In program trading we normally gives inputs like the required buy spread and sell spread to execute the trade and the number of pair quantity etc. Some algorithms do not even require any input. Algorithms can be made in such a way that the program start quoting in the illiquid market and when the system gets a fill in this illiquid market then it sends a market order in the liquid market to grab the required buy spread.

What are the advantages of using algorithms?

• Efficiency of algorithms comes from the fact that the whole process can be done in a millisecond’s time. Thus saving Time.
• Accuracy of execution improves as time lag is reduced and better prices can be quoted
• Since the system doesn’t get fatigued, continuity of process is ensured

There are so many other way to do arbitrage like calendar spread, multi exchange trade, main mini spread, different exchange of two different countries and other ways also and program trading used in those all types of arbitrage.

Author: Bratin Mukherjee, Analyst, Kredent Group

Praveen Bajaj, Head – Research, Kredent Group

Related posts:

1. All about algorithmic trading
2. Options glossary
3. Open Interest – Essential Trading Tool