I know that at and given time for example there exists a fair value between the S&P cash index, and the S&P Futures. I know that if the gap increases too much the index arb'ers will sell the futures and buy every stock in the S&P cash index. But how exactly does that work??? If I Sell the Futures and buy 500 stocks in the S&P, I end up with 500 stocks long, and short Futures contracts? Confused...
that's how it works. it only really makes money when there's a pricing discrepancy, which there almost never is. (otherwise it'd be arb'ed away right away). sometimes there's a (very small) discrepancy between the DIA and the actual bucket of stocks, but that is usually extremely short lived too.
You can sell the futures and buy stocks when there is a gap between the prices. The gap will soon go to 0, and then you can buy the futures and sell the stocks and keep the profits.
Correct, I would go further into this but I paid a large amount of money to learn arbitrage. Therefore I would need to get paid.
why are you confused??You appear to have a good handle on it. The whole trade is really a funding trade,unless one trades optimised or tilted baskets.. There is more to the trade,but you essentially have the basics down
There is a certain fair price band within which the futures may diverge from a basket of index representative stocks - already accounting for basis, whereby it really isn't worth it for the big boys (transaction costs, slippage, etc). Once prices move outside these bands then the programs usually kick in to bring everything into alignment, and the world is once again a happy place. You don't necessarily need the whole SP500 basket, as long as you have a sufficiently representative set. Similar sort of thing with dispersion trading which is sometimes moronically referred to as volatility arbitrage.
Thank you all for your posts, but I'm still a bit confused... but if you sell futures and buy stocks how do you get flat? like I was thinking there is some way you can cash in your future contracts for Stock?