Always on the lookout on ways to make a buck, I think I found one. I like how Jonathan put the Intrade futures quote board on the frontpage of Chicagoboyz. But the spreads between the bid/ask have always looked huge to me. For example, the “DJIA closes at/above 10750 on Dec 31” future has the bid x ask at 28 x 31. Why not arbitrage it?
Here’s what you do. Buy a contract at $28, and short a contract at $31, or as close to the bid/ask as possible. Say the DJIA closes above 10750 on Dec 31. Your long contract will settle at $100, and your short contract will settle at $100 as well, meaning you need to deliver $100 to the buyer of the contract that you shorted. Your proceeds from the short is $31, so you lose $69 on the trade. But since your long also settled at $100, your gain on the long contract is $72. Hence your overall profit is $3. Since your committed capital is $28 + $31 = $59, so your return is about 5%. Not bad since you have zero economic risk.
Say the DJIA closes below 10750. Your short will settle at $0, for a gain of $31. Your long will settle at $0 for a loss of $28. So you still make the $3 spread, at zero economic risk except tying up capital. Not bad eh?
Update: Jonathan emailed me and raised a good point that with the bid/ask at $28x$31, you can’t sell at $31 and buy at $28. I should clarify and say that you would probably have to put offers out there for a little better than the market rate, for example, offering to sell at $30.75, and bidding $28.25 to buy. That way sellers who want to sell can get a price a little better than the bookmaker is bidding, and buyers who want to buy can get a price a little better than the bookmaker is asking for. So in a sense it would be trying to scalp a few points from the market. But since you have a paired long and short that will for sure settle, the arbitrage is to capture the wide spread in the market prices.
I’m guessing that there’s a $3 spread because that’s about the limit of where you can execute the trade and make decent money once you count in trading expenses and the cost of money. No doubt, there are nice sophisticated trading programs that issue just such contracts whenever the spread on the DJIA exceeds their magic number.
What you’re talking about is called “cutting the spread”, and it’s what has happened and continues to happen in every market. As a market matures and attracts more participants, the bid/offer spreads narrow, as people do exactly what you are proposing. The inherent problem is: Is the market that I am going to cut liquid (active) enough for me to have a reasonable chance at getting the offsetting trade filled? Remember, you may sell it at 30.50, and end up having to bump your bid up 50 cents at a time until it is a loser. The more liquid the market, the tighter the spread and vise-versa.
Excellent point Andy. The Intrade market isn’t very liquid, hence the big spreads. So fulfilling the orders is the biggest hurdle. If Intrade continues to catch on, as with all perfect market theory situations, the spreads will be competed away.