A stock index is meant to track a basket of stocks. The S&P 500 is a famous one. It tracks a group of 500 of the largest and most influential U.S. stocks, making it the benchmark indicator for equity performance. Ask someone "how did Wall Street do today?" and they'll likely tell you how much the S&P 500 moved.
While it represents a high-profile case study, the S&P 500 is just one example. There are hundreds of stock indexes, each targeting different baskets of stocks. Some follow general market performance (the S&P 500, the Dow Jones Industrial Average). Others target specific industries or particular market cap sizes (small cap, mid cap, etc.).
These indexes are fundamentally mathematical constructions. We say they track "baskets of stocks," but it's not like there's an actual basket somewhere. As such, there can be some space between the theoretical performance of stocks in an index and the performance of the actual stocks that underlie that index.
Index arbitrage looks to profit from these potential gaps in performance. An investor would buy (or short) a futures contract based on a particular index, and then take the opposite position in the actual stocks that make up that index. The theory is that, over time, the little mispricings that happen in the index system will work themselves out. The gap will close. When it does, the arbitrage position will squeeze out some profit.
Related or Semi-related Video
Finance: What is Arbitrage?22228 Views
finance a la shmoop what is arbitrage? not yourbritage or mybitrage but
arbitrage what it's been a while since we conjugated anything around here oh ok [Man talking about arbitrage]
so moving on arbitrage is a riskless trade you make guaranteed profits just
for being on top of things or in the right place at the right time or you're
there when opportunity comes a-knockin think about the stock exchanges in the [Men working in stock exchange]
pre-internet era around the world communication well it was relatively
slow and expensive back then especially when it came to sharing data one [Man talking into olden microphone]
relatively easy arbitrage or riskless trade opportunity that came about was
when stocks traded at one price on the various european exchanges versus the
prices it traded at on the US exchanges like shares of IBM might have been [Share price graph of IBM]
offered for sale at $165 32 cents on the london stock exchange even net of
currency conversion prices remember the Brits were on the pound system but in
the US investors were paying $165 47 cents a share
so an easy 15 cents a share was made all day long in buying the shares of IBM in
London and then just selling him back here in New York well both sides of the
trade were made at the same time it was riskless it was arbitrage and arbitrage
became a whole industry for a while until the capital markets went to work
and spreads tightened as communication got more liquid and people sprayed a [Spreads word becomes narrower]
bunch of wd-40 on information passing around the world and then that 15 cent [15 cents transfers from US to England]
spread from London to New York became more like a penny or a tenth of a penny
or at least close enough of a spread so that it was no longer worth bothering to
try and make a buck or a billion whatever those arbitrageours made in
those days
Up Next
What is a Country Basket (Index Fund)? Investing internationally can be a challenge, as foreign exchange, different accounting rules, time zones an...
What is the difference between mutual funds and index funds? Mutual funds are professionally managed. Those investors trade shares and realize taxa...