Reverse Arbitrage? SLB?

May 16, 2013

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Traders,

Basu, who works on our dealing desk, thought he had spotted an opportunity. I realized that over the last 15 odd years in the market, I must have had the same discussion with so many people who get confused on the so called riskless/arbitrage opportunities that can make a lot of money. Typically, you will never find a riskless opportunity yielding you more than 10-12% annually. If you find any, think & analyze twice, you could be wrong. Find following the email interaction between Basu and I: Today is 16th of May and SBI stock is trading at 2430 and May Futures is trading at 2390 a discount of Rs 40.

______________________________________

1. Basu:

We have a spread of Rs. 40 in SBI for May Series. If any of our client has a decent quantity of around 2000 + of delivery we can give this strategy.

Calculation

Quantity Margin Required Investment Time Frame Returns

1,000 3,20,000 5,00,000 10 Days to Expiry 40,000 Rs.

So client will be making Rs. 40,000 on an investment of 5,00,000, 8% return in 10 Trading days.

Is it a good deal ?

2. Nithin:

It must be going ex-dividend somewhere in between, otherwise usually on a stock like this there won’t be any opportunity.

Check and let me know…

@ Nik (Nikhil manages the prop trading at Zerodha), if it is not going ex-dividend, we can borrow SBI from ILFS and do a reverse arb.

3. Nithin (a few minutes later):

Going ex-dividend on 24th May, 35 Rs (350%), so no opportunity.

But, Basu, it is good to discuss these kind of scenarios only then will others learn.

@ Everyone else: you can see the trail email for what Basu was talking about…

4. New guys on the team:

Nithin, we didn’t understand what the last email meant.

5. Nithin:

Guess a lot of you wouldn’t have understood all that talk…

Basu saw SBI trading in Cash at 2430 and futures trading at 2390. Ideally futures should be trading more than spot. Futures = Spot + Cost of Carry.

But here you see the futures trading at Rs 40 discount. Usually when any such mispricing happens, we get an opportunity to arbitrage.

Basically, you see the same mangoes in Bangalore selling at Rs. 100/kg and in Chennai at Rs. 200/kg. You know there is a profit you can make if you find a buyer in Chennai and a seller in Bangalore, and you make a riskless profit. Such trades are called arbitrage.

In the above case the idea is simple, sell cash at 2430 and buy May futures at 2390. On the expiry of May Futures (30th May) cost of carry becomes zero, so future price and spot price becomes the same. So basically you can make a riskless profit of the difference between spot and futures which is Rs 40.

1 lot of SBIN futures is 125 shares, so you can sell 125 shares and buy 1 lot of futures and make a riskless profit of Rs 125 x 40 = Rs. 6000.

Such an arbitrage where you sell the spot and buy futures is called as a reverse arbitrage.

If you buy spot and sell futures it is called a straight or plain arbitrage.

Interesting?? ;)… Here is the problem though…

To sell SBI shares, you need to have the shares right?? What do you do if you don’t have shares??

If you don’t have shares you cannot participate in a reverse arbitrage. But there is this interesting tool that the exchanges have created: SLB (Stock Lending and Borrowing). In this mechanism, you can borrow shares from someone who has got SBI shares.

So if we are looking at setting this reverse arb, and if we are registered for SLB, we can go to IL&FS (empanelled to do SLB) and see who is lending shares. If someone is lending shares, we can borrow them. Why would a guy lend his shares? He doesn’t intend to sell it and it is sitting idle in his account. Similar to how you make an interest by lending money, you can make money lending shares.

So assume there is this guy who is lending 1000 shares (8 lots of futures) for an interest. You have to borrow the shares from him using the SLB mechanism. So 1000 shares at 2420 is 24.2 lakhs, 125% of this (around 30 lakhs) has to be deposited with IL&FS before borrowing the stock. The money has to be deposited, so that after borrowing you don’t dissapear.

Once you borrow these shares, you can sell it in the market at 2420 and at the same time buy 8 lots of futures (8 x 125 = 1000) at 2380. Margin required to buy 8 lots of futures: Rs 3 lakhs (around Rs. 40,000/lot).

On the expiry day, both futures and spot price will be the same. You sell the futures and buy back the stock. Give the lender the stock you bought back and get back your 30 lakhs.

So for this trade you would have blocked 30 + 3 = 33 lakhs and you would have made a riskless profit of Rs. 48000 (8 lots x 6000/lot).

A profit of Rs. 48000 for 34 lakhs works out to around 1.4%. Out of this 1.4%, the cost of blocking 34 lakhs for 10 days, the interest to the lender and other costs will add up to 0.4% (if you are trading at Zerodha , otherwise this could be a lot more) so you probably will make a net profit of 1%.

Even 1% for a riskless profit in 10 days is a brilliant return, considering an FD will take almost 1.5 months for the same.

Here is the truth though: today the business of cash/future arbitrage either straight or reverse is a fight of super computers. There are hedge funds, trading firms out there who have super computers co-located on the exchange to catch any riskless return of more than 10% per year. Yes 10% per year. If we suddenly see an opportunity of 1% for 10 days, you know there must be a catch.

The most important rule in the market is: if it seems very easy to make money, you must be missing something, nothing like easy money.

So here is the actual scenario, which Basu had missed:

SBI had announced a dividend of Rs 35/share. The stock goes ex-dividend on 24th of May.

In stock markets, usually when a dividend is announced, the stock price goes up by the dividend amount on the record date and it reduces by the same amount on the ex-dividend date.

So what it means is if SBI was at 2350 and the dividend of Rs 35 was announced, on the record date the stock will go to 2385. On the ex-dividend day, since the dividend is already paid, the stock price comes down by the same amount, in this case it will automatically come down by Rs 35 on 24th May. People who are holding futures don’t get the benefit of dividend (only stock holders), so on the record date the stock goes up by Rs 35 but the future price would stay the same. If you don’t know that it is going ex-dividend before the end of expiry, it will give you an illusion of an arbitrage opportunity.

In the above case, on the 24th of may, the stock will drop by Rs 35, so basically what would happen is that the difference of Rs 40 that you are seeing today, will automatically just become Rs 5. So yes the short position in SBI stock will make you a Rs 35/share profit, but this Rs 35/share when you are returning the share back to the lender has to be given to him as it is a dividend credit for his shares. So the opportunity in this trade will be only for Rs 5. At Rs 5, you will make 0.15% for 10 days, you rather keep the money in FD than do all this circus. :))…

Phew!!!! That took some effort, but hopefully it clarifies all your doubts.

Hopefully the above interaction helps you to discard any such similar opportunity that might come by your way in the future. I hope this also gives you a basic idea on what a reverse arbitrage is and why we have SLB (Stock Lending and Borrowing). Other than for cash/future arbitrage, SLB is also helpful when you are bearish on a stock which is not trading on futures,so can’t hold a short position overnight. You can borrow and sell, buy and give it back once your trade has played out.

Happy Trading,

Nithin Kamath

CEO @ Zerodha and partnering startups through Rainmatter to help grow and improve the capital market ecosystem in India. Love playing poker, basketball, and guitar. @Nithin0dha on Twitter.

44 comments

  1. Bipinkumar says:

    How to reset trade book and order book in Z5 platform.

    • Nithin Kamath says:

      By reset, I guess you are trying to say reset the columns back to how it was originally, you cannot. But you can move those columns to your preference.

      First on the order book you have ” +” icon, click on it, the order book becomes a big window, left click and drag the columns to your preference.

      Hopefully this clarifies.

  2. Gkrishnan says:

    Hi Nithin,

    Thank you for time you spent for this write up. It really helped me.

    Regards,
    Guru

  3. basu says:

    tHANK yOU !!! cRYSTAL cLEAR aBOUT sLB cONCEPT ….

    bUT iF i aM bEARISH aBOUT a pARTICULAR sTOCK, i wILL jUST sELL dELIVERY aND bUY bACK lATER…
    hOW sLB tOOL wILL hELP ?

    • Nithin Kamath says:

      Basu,

      You have to first borrow the stock and then sell in delivery.

      So for example if SBI is trading at 2300, instead of going to the futures market, you can go to the SLB mechanism, borrow SBI stock and sell it in the market.

      Once the stock price goes down, you can buy back the stock and give it back to your lender.

      SLB is really popular in countries like Brazil and Korea. Unlike in India SLB is more popular than futures. SLB improves the market depth considerably and measures taken by Indian exchanges should help in the same.

  4. anandpatel says:

    Sir,
    everything is clear except the fact that when i do a reverse arbitrage,y would i worry if its going ex-dividend or not,when i go for reverse arb all i am worried abt is the price difference to close down which would eventually happen on the expiry,sir andhra bank may futures on 2nd may was trading 4 rs higher than june future,and then came a spike and than june futures started trading at 0.20-0.30 paise higher than may futures,i entered into spreads for uco bank which i closed down with minor profits,although not 100% risk free.also sir can i benefit from andhra bank july futures using SLB as it is trading abt 4 rs cheaper than june futures.plz enlighten me!!

    • Nithin Kamath says:

      Anand,

      You are getting confused, what you are talking about is a calendar spread. Calendar spread is when you take a trade to make profits between difference in prices of 2 different series. Like the way you have mentioned between may and june futures.

      The arbitrage I am talking about is the difference between spot and futures. Reverse arbitrage is when futures is trading at a discount to the spot. So if stock is trading at 2500 and futures at 2470, this is a reverse arb opportunity, unless the stock is going ex dividend, in which case the stock price will come down on the ex dividend date..

      Hope this helps…

  5. viewofmind says:

    very good write up for SLB concept and reverse arbitrage
    Thanks….

  6. anandpatel says:

    Sir,
    extremely sorry for mixing calender spread with rev.arb,again same question let us say i know sbi going ex dividend,even then y would i not borrow sbi and sell the shares and buy futures,this 30-40 rs difference will close down and i would get risk free return on expiry(,and i suppose the dividend will directly go in the bank a/c of orginal holder),so eventually purpose solved;coincidence of spot and future prices,y should we bother if its giving dividend or not?

    • Nithin Kamath says:

      Anand,

      Will add it to the blog as I didn’t really explain this question there.

      Here is what happens, You sell the stock at 2500 and buy futures at 2470. In between on one day the stock goes ex-dividend(assume rs 30), so the stock price and future price is around the same.

      At this time you can sell the futures and buy back the stock.

      Here is the catch though, when you are returning the stock back to the lender, you have to also give him the dividend. So basically the stock plus Rs 30 as dividend. Your reverse arbitrage opportunity was only for Rs 30 and everything has to be given back to the lender.

      Hence the strategy would make no sense to take.

      Hopefully this clarifies.

      Cheers,

  7. rahul_agarwal says:

    Hi Nitin
    What is ur comment on rev arb using SLB & OFS. Only risk of none/less allocation in OFS is there.

  8. arcus says:

    “SBI had announced a dividend of Rs 35/share. The stock goes ex-dividend on 24th of May. In stock markets, usually when a dividend is announced, the stock price goes up by the dividend amount on the record date and it reduces by the same amount on the ex-dividend date. So what it means is if SBI was at 2350 and the dividend of Rs 35 was announced, on the record date the stock will go to 2385. On the ex-dividend day, since the dividend is already paid, the stock price comes down by the same amount, in this case it will automatically come down by Rs 35 on 24th May.”

    That is only true if the market sentiment is extremely positive or the dividend payed out was more than what the market was expecting and hence the market reacted positively.

    However, what usually happens is that if SBI is trading at 2350 before ex-dividend, then SBI will simply fall to 2315 on the ex-dividend day. Its not true that it will rise to 2385 from 2350 and then again fall to square one i.e. 2350. That would imply that the dividend was payed out of thin air without any affect on the equity.

    Whenever a dividend is payed the stock price falls by an equal amount in an efficient market because a reduction in assets (cash payed out) reduces equity (stock price).

    • Nithin Kamath says:

      Arcus,

      thanks for pointing out,

      the idea of the conversation above was to explain in the easiest possible way on why it could happen.

      We have a lot of clients who keep getting into calendar spreads and etc thinking that it is an arbitrage opportunity. It was the easiest way to let them know it is not and avoid them from taking those trades.

      Cheers,

  9. msk_14 says:

    Please tell me how I can become eligible for SLB? and what can i expect to earn on lending of SBI 1 lot (125 shares).

    Regards,
    msk

  10. NAVANEETH says:

    HAI NITHIN I HAVE A REQUEST REGARDING PI.PLEASE INCLUDE OPTION TO CHANGE THE COLOUR FOR +VE AND -VE CHANGES AS IN NEST TRADER.VIEWING RED AND GREEN FOR A LONG TIME IRRITATES EYES. NOW IT ONLY HAVE OPTION TO CHANGE THEME.

  11. Rahul says:

    Hello,
    I wanted to know that if I invest on CNC stock, and the dividend is being paid, then where does that dividend get credited. Is it on my Zerodha account (which is shown as fund in the kite) or will it be deposited to my bank account?
    I am thinking of investing some CNC stock, hence the query.
    Thanks
    Rahul

  12. muruganandam says:

    sir,
    All
    the
    stocks
    trading
    in
    nse
    is
    eligable
    for
    slb.

  13. muruganandam says:

    thank
    you
    sir

  14. parth parikh says:

    sir, i wanted to know if instead of SLB i choose to buy stock for cash-future arbitrage (which required more than 10 l) is it safe ? As i always spot mim 50 paisa to 1 rs gap in cash-future in current series of future.As per my calculation if i make 10-12 k per month by using 10 l i can easily beat FD and sometimes i can earn more also.

  15. Raman Ahuja says:

    Hello Nithin Sir,
    If I’m getting it correct from this blog, future and spot will be same at future expiry. But still I would like to be bullet-proof, so providing some numbers to you.

    I was looking at KPIT, day-end price on 23-Sep-2016, Friday:

    Cash Market Future Market (Lot Size: 4000)
    Bid Ask Bid Ask
    130.50 130.75 131.10 131.30

    Gap is of 0.35 (131.10 – 130.75) between Future selling price and cash market buy price.
    Is arbitrage trade possible? Given that future contract expiry is on 29-Sep-2016, Thursday.

    • 0.35 is around Rs 1300 per lot. TO earn this you will need around Rs 66k for futures position and Rs 5lks (4000×130) for equity. So total cost is Rs 5.6lks with maximum profit potential of Rs 1300. If you reduce STT etc, this would be lesser than Rs 750. Don’t really see an arbitrage opportunity.

      • Raman Ahuja says:

        Less than 750!!! Probably best to short call when prices are falling or short put when prices are moving north

        Thank you again for saving my margin money.

  16. rahul jadhav says:

    how can we sell the stock which we have borrowed,it is not in our ownership?

    • Venu says:

      You’ll be borrowing it on the guarantee that you’ll be returning the borrowed shares. When the shares are lent to you, you can sell them whenever you wish to.

  17. Amar says:

    Is there any automated way to find this arbitrage opportunity and execute it through zerodha ?

  18. vasant walavalkar says:

    how much interest should we required to pay on borrowed securities. for eg. borrowing 1000 share of sbi for 10. how much interest, we required to pay.

  19. Vijay swain says:

    Is zerodha platform allows us to do automated trade where the arbitrage opportunity generates.

  20. mehul says:

    Hello Sir,

    I am wondering to know about the scenario of Fut-Fut arbitrage instead Cash-Fut arbitrage.

    I mean to say just like cash and future price may have difference (discount or premium), there may also be a difference in between Jan, Feb and March future of the same stock.

    As per my knowledge, Zerodha also offers a margin benefit in case of taking buy/sell positions of future of near and next of same stock.

  21. subash says:

    Hi Nithin,
    How can I register for SLB service? I called zerodha customer care and asked for this service but i got negative response saying this is not offered from zerodha. I don’t see relevant forms as well on zerodha site. Please guide me how to start

  22. Nirmal says:

    How do I apply for lending shares ?

  23. Om Apte says:

    Hi Nithin,

    Will this plain Arbitrage thingy work for a small investor like me if I already hold or in time hold a ‘lot of a F&O stock’ and then short the future at the start of series if its at premium.?

    Lets say over time I accumulate TCS 250 shares or any other F&O stock, and then keep shorting future for that stock and hope to make some risk free money..at end of series..?

    does this make any sense..?

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