Arbitrage between Sensex and Nifty futures! Will it be really useful for traders?

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What do we understand by arbitrage? Let us leave out cash-futures arbitrage for the time being. Let us look at arbitrage between stock exchanges. Is it possible to arbitrage between the Nifty futures and Sensex futures? Of course, if there is a price difference in the same stock between the BSE and the NSE, then it is possible to buy in one exchange and sell in another exchange. But that is a very theoretical possibility. In reality, such differences do not exist for more than a millisecond on the screen. Let us look at a novel way of arbitrage which is the ratio arbitrage.

How does ratio arbitrage work in practice?

If you have been a trader in gold and silver, you must be familiar with the famous gold/silver ratio. They plot the ratio of gold prices and silver prices over time and then calculate the ratio between the two. Then a range is decided and appropriate trades are made betting on mean reversion. Check the chart below.

ratio chart Arbitrage between Sensex and Nifty futures! Will it be really useful for traders?

Data Source: NSE and BSE

The above chart is a 1-year chart of the ratio of the Sensex versus the Nifty on a pure numerical ratio basis. We have considered the closing price of the Nifty and the Sensex on each of the days in the last one year and plotted the ratio. That ratio has been plotted. What are the inferences that we can draw from here?

  • At the lower end of the range, there is no clear support that is presenting itself. Hence we have not drawn any support line for the Sensex / Nifty ratio. That can only be drawn if there are signs of accumulation around a particular ratio.
  • On the other hand, there appears to be a congestion zone when the Sensex / Nifty ratio touches 3.40 as can be seen from the chart hitting that ratio multiple times and correcting. At that point, arbitrage can be created by betting on the ratio reverting to the mean. Effectively, you sell Sensex futures and buy Nifty futures and make a profit on this mean reversion arbitrage.
  • One year may be a shorter data point and we may have to look at a longer time frame to arrive at congestion zones on both sides. However, there is a risk factor here. These are just technical supports and resistances for the ratio and hence this is purely a statistical arbitrage.

Cross margining and the room for Sensex / Nifty arbitrage

There have been some developments that make arbitrage between Nifty and Sensex more realistic. Here is what you need to know.

  • SEBI has permitted cross-margining for off-setting positions in highly co-related equity indices to facilitate efficient use of collateral. Sensex futures and Nifty futures have a 99% historical correlation. As a result, the actual settlement can be close to zero if a trader has offsetting positions on BSE and NSE.
  • The second big change is interoperability that was also permitted among clearing corporations during this year. Under interoperability, a separate margin to trade stocks on the NSE and the BSE is not required. The trader can merely choose a clearing corporation of choice and execute trades on the other exchange platform that gives the best ‘spread’ without dual margin. This could also be a boost for arbitrage.

Challenges remain if this has to become a big arbitrage

Cross margining and interoperability are surely going to be a boost for arbitrage between Nifty and Sensex. However, a few more challenges will have to be addressed.

  • Sensex futures and Nifty futures will require more parity on volumes and institutional participation before there can be full-fledged arbitrage. Till volumes converge, traders may be skeptical about arbitraging.
  • The cost structure of the two exchanges must also be at par so that there are no hiccups on the regulatory or statutory cost front. That would be a good starting point for arbitrage.
  • Finally, any arbitrage is unlikely to be for manual trades. Such arbitrages will be seen briefly and vanish. Only traders with high-end algos and low latency server systems will be able to capitalize on this advantage.

There has been a start but it would need more bells and whistles before we see arbitrage between Sensex and Nifty futures. Only then, the ratio chart will also mature and give more realistic signals.

 

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