An arbitrage or pairs trade opportunity involves buying and selling two correlated financial instruments at the same time. The goal of a pairs trade is to profit off the difference in price between the two. This type of trade can work due to pricing discrepancies between two financial instruments that react to general market moves similarly.
Backtest to Find Correlations
By backtesting S&P 500 (ES) and Nasdaq (NQ) futures contracts on charting software you may be able to spot correlations. For example, there are several periods in the past year when the Nasdaq (NQ) had similar price moves to the S&P 500. During those similar moves however, the Nasdaq (NQ) declined at a steeper or quicker rate than the S&P 500 (ES). This more rapid decline in the Nasdaq (NQ) in comparison to the S&P 500 (ES) is where your potential opportunity may be.
Looking at the chart below, there are four price moves (circled) when the Nasdaq declined at a steeper rate than the S&P 500:
Execute a Futures Arbitrage Trade Opportunity
If you were to buy the S&P 500 while selling the Nasdaq futures contract, you might find an opportunity in the difference in price. The trade idea is to hedge against a move up in the Nasdaq by buying the S&P 500. This will allow you to potentially take advantage of the steeper or more rapid move by the Nasdaq.
Before you enter the pairs trade by selling the Nasdaq and buying the S&P 500 simultaneously, you should plan your exit. There are many ways in which exiting the trade could be implemented. One example is programming to buy (Nasdaq) and sell (S&P 500) orders on your automated trading software to occur once predetermined price levels occur. This objective of programming two separate buy (Nasdaq) and two separate sell (S&P 500) stop exit orders is to limit potential loss and protect potential profit.
Ready to get started practicing spotting potential pairs trades with NinjaTrader’s free trading simulator & live market data? Download Now and register for a free futures data trial to start exploring the markets!