Introduction to Cash and Carry Trade
Cash and Carry trade is an arbitrage strategy that benefits the traders from the mispricing of the underlying asset and its future derivative. This strategy involves buying the underlying asset of a futures contract in a spot market and carrying it for the duration of arbitrage. The potential profit through this trade is achieved by the eventual correction of the mispricing.
This trade is executed by entering a long position in an asset and simultaneously selling the futures contract. The traders profit from the cash and trade strategy as long as the purchase price plus the price of carry is less than the price of money received by selling the futures contract.
Under the cash and carry trade strategy a purchased commodity or asset is held until the contract delivery date and is used to cover the short position which is created by selling the futures contract.
How does a Cash and Carry Trade Strategy work?
The basic idea behind the cash and carry trade strategy is to take advantage of the mispricing and the price difference between the underlying asset and the future derivative of that underlying asset.
The cash and carry trade is also known as basis trade where basis is defined as the spot price of an asset and its corresponding futures price. The traders use this difference between the spot price of an asset and its future derivative to benefit from the cash and carry trade.
The basic steps of the cash and carry trade are pretty simple and go as follows:
- An investor focuses on two mispriced securities with respect to each other that is the difference between the underlying asset and its future derivative.
- The investor then purchases the underlying asset and sells the futures contract. Then the purchased asset is held until the futures contract expires and then delivered.
- In this case, whatever the delivery price may be, the trader will only benefit if the price at which they purchased the asset plus the cost of carry is lower than the cost of the futures contract or the money which they received after selling the futures security.
The investor often knows how much money he can make on the delivery date and the cost of the security or asset because of the long position. This somewhat ensures the investor profit through the cash and carry trade. However, the profit will still depend on the difference between the price of the asset and its futures contract.
