CFD Arbitrage is increasingly available as more and more online brokers provide the opportunity to trade CFD’s or Contract For Difference on various instruments such as stocks, futures, commodities or even FOREX. The range of financial instruments significantly increases the number of arbitrage possibilities that occur. Additionally, despite their availability, many CFD products are illiquid. Therefore, should arbitrage opportunities appear, they may last longer than usual, at least in arbitrage terms. This could be as long as several minutes, allowing for sufficient trade execution without significant market impact.
The availability of on-line service providers and the significant reduction in commission rates has led many traders to pursue trading and investment strategies utilizing CFD products.
CFD Arbitrage Example
As a pairs trader employing a statistical arbitrage strategy, one can buy, or go long a contract for difference on the stock of the underpriced company within a given industry sector and sell, or short a CFD on the stock of the weakest or overpriced company within that same industry. The outcome of this strategy is one of two possibilities
- the share underlying the long CFD gains more than the share underlying the CFD you shorted, or in the event of a fall, it loses less value than the short CFD
- the share underlying the short CFD rises more than the share underlying the long CFD you bought, or in the event of a fall, it declines in value less than the long CFD
Relative Value investment strategies such as Pairs trading or Statistical Arbitrage are generally seen as a relatively low risk strategy but it is still possible for stock specific factors to cause the spread to widen unexpectedly. Unexpected macro factors such as the COVID-19 pandemic must also be factored in to risk calculations. This can result in losses on both sides of the trade. It is prudent for traders to maintain stop loss orders in this type of strategy in case stocks drift apart to protect capital.
Single Product Arbitrage
The ability to enter and exit a position is a crucial feature of CFD’s as the key to the successful use of arbitrage is speed. Some traders use automated trading software. These systems alert the trader to changes in prices whilst algorithms execute their arbitrage strategy. No calculations are necessary as the software instantly detects and executes arbitrage opportunities. This type of arbitrage strategy may be applicable to CFDs, especially ones whose prices are derived from an underlying futures contract. These would commonly be Indices or Commodities products.
CFD arbitrage is traded by comparing the feed of the CFD to the underlying futures contract. If there is a discrepancy in the prices, an arbitrage trade can be executed.
Additional Risk Warning
Merger Arbitrage Limited advises you to make sure CFD trading matches your trading objectives. This type of trading, as with spread betting, is not appropriate for all investors. Prior to trading, ensure all the risks are fully understood. If required, seek independent advice. Only speculate with money you can afford to lose. A CFD is a leveraged investment product, thus they carry a high level of risk to your capital. It is possible that losses can exceed your initial deposit. The Financial Conduct Authority (FCA) is responsible for the regulation of CFD trading in the UK. It has previously demonstrated its tough stance towards this area of the industry by forcing service providers to limit leverage to 30:1, (limit, yes LIMIT!) with additional limits of as little as 2:1 on trades involving more volatile assets.
