How to Use Arbitrage Opportunities in Commodities?

Many times, it happens that an asset is available in different markets at varying prices. This difference in pricing may happen due to inefficient pricing or based on demand and supply figures. The price difference here creates an arbitrage opportunity that allows you to generate returns by buying and selling assets at different prices in different markets.You may apply various trading strategies such as arbitrage, long-term investment , or purchase and sale while dealing with the financial market. The strategy may depend upon your risk tolerance, financial objectives, tenure, and capacity of investment. When the market is unstable, you can trade with a minimum risk and good return through the arbitrage strategy. Let's understand more about arbitrage trading and its strategies:

The term “Arbitrage” refers to the buying and selling of an asset to obtain profits from the price difference of that asset in different markets. These assets may be a commodity, security, or currency that can be purchased and sold simultaneously across markets. Arbitrage helps to improve market efficiency and liquidity for trading. An arbitrage fund , similar to equity funds is also available for investors who wish to invest in arbitrage of securities and shares.

In general, commodities need storage space and transportation to make them available across the world. Also, they are traded in different forms across the markets. Many times there is a difference in the price of a commodity in spot and futures markets and also across exchanges.This difference in price creates an arbitrage opportunity wherein the commodities can be purchased and sold in different markets at different rates, to generate returns for the investor with minimum or no-risk. The individual who identifies the arbitrage opportunity across markets and is involved in commodity trading is called a commodity arbitrageur.

Below are some preconditions needed for an arbitrage opportunity to exist:● The given asset is priced differently across different markets.● The two assets having identical cash-flows must trade at different prices.● The asset has different future and current trading prices.Let’s look at the different arbitrage strategies you can opt for while trading in commodities.

The cash and carry strategy aims to take advantage of pricing inefficiencies for an asset in the spot and futures market to generate profits without any risk. The arbitrageur purchases a long position in the said commodity and simultaneously sells a position through a futures contract for the same asset. The arbitrageur carries the asset until the expiry of the contract and delivers as per the futures contract. This is also called as basis trading sometimes.For example, An asset currently trades at Rs100 with an additional cost of Rs 5 as carrying cost. Also, there is a futures contract available for the same asset at Rs 108. The arbitrageur, upon identifying this opportunity invests as per cash and carry strategy to generate a profit of Rs 3.The strategy is profitable only if the cash inflow upon selling as per futures contract exceeds the acquisition and carrying cost of the asset. Also, this strategy is not always completely risk-free. The additional carrying cost may sometimes increase that brings down the profit margin.

As per this strategy, the arbitrageur takes advantage of the price difference between two futures contracts of the same asset or commodity. It is focused on buying a futures contract for a commodity and selling it as per another futures contract to generate profits. Spread trades are less volatile and lower the risk in trading as compared to straight futures trading .For example, let’s say that a commodity X march 2019 contract is trading at Rs 500 per unit and another contract of commodity X June 2019 is trading at Rs 450 per unit. Now the arbitrageur can decide at the time of expiry of the march 2019 contract whether he wishes to sell the march futures contract and buy the June futures contract. It depends on how the arbitrageur perceives future prices.

Inter-exchange is another strategy that can help you in the arbitrage trade of commodities. The arbitrageur exploits the price difference for the same commodity on different exchanges for the same contract expiry. This difference in price across exchanges calls for arbitrage opportunity. The price difference of the same commodity mainly happens due to liquidity, instability, and specifications of the contract.For example, if the ABC March 2019 futures contract is trading at Rs 500 per unit on exchange 1 whereas it is trading at Rs 550 per unit on exchange 2. Upon identifying this opportunity, the arbitrageur can buy the futures contract from exchange 1 and sell it as per the futures contract on exchange 2, thereby making a profit of Rs 50 per unit.

This strategy is applicable when the arbitrageur is dealing in two different but related commodities. The two commodities are purchased and sold in the same exchange on the same contract month to take advantage of the price difference for generating profits.For example, arbitrage can be created between mustard seed, mustard oil, and related products, to generate profits from the price differences. Let’s say the price of mustard seed is Rs 1600 per ton, in the June 2019 futures market whereas the price of mustard oil is Rs 1500 per ton in the same futures market.Now if the arbitrageurs perceive that this difference of 100 Rs may increase or decrease as per the current market situation, he can buy the mustard seed June contract and sell off the mustard oil June contract or vice versa as per his market understanding.

Since the arbitrageur buys and sells commodities at different prices which are known to him for different markets, there are lesser chances of risk. The only issue with commodities is that there may be additional costs associated with storage and maintenance until they are sold. This may slightly affect profit margins in some cases.Though the risk is limited, you must have a good knowledge of different markets related to the commodity you are dealing with. It helps you to take maximum advantage of pricing differences by exploiting a suitable trading strategy.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.