There are two types of index arbitrage:
1. When the spot index is undervalued and the futures contract for one delivery month is overvalued, investors can sell futures contracts, buy constituent stocks according to the index weight and establish arbitrage positions. When the spread between spot and futures tends to be normal, arbitrage profits can be obtained by closing futures contracts and selling all constituent stocks at the same time. This strategy is called forward basis arbitrage.
2. When the spot index is overvalued and the futures contract for one delivery month is undervalued, if short selling is allowed, investors can buy the futures contract, and at the same time, short the constituent stocks according to the index weight to establish an arbitrage position. When spot and futures prices tend to be normal, closing positions at the same time is profitable, which is reverse basis arbitrage.
The essence of spot arbitrage is speculation on the basis of spot index and futures index. The change of basis can be analyzed and predicted, and correct analysis can make a profit. Even if the analysis is wrong, the risk of arbitrage is much lower than that of one-way speculation.