Arbitrage trades are referred to as near-pure-alpha strategies. This is because the strategy is set up to generate gains regardless of the market direction. Previously in this column, we discussed how to fade rates using futures and how to fade prices using options. Typical argument against fading rates and prices is that the capital required to set up the trade is large and the return modest. So, why engage in such strategies? This week, we discuss how to decide if the strategy to fade rates is optimal to set up.
Price convergence
To recap, fading rates involves shorting futures and buying the underlying and typically holding the position till expiry. The strategy relies on price convergence; futures price will converge to the underlying price at expiry. Note that the number of shares of the underlying must match the permitted lot size of the futures contract. That requires large trading capital with modest returns. So, is the strategy optimal to set up?
The strategy is set up to capture the price differential between the underlying and its futures, when futures are overpriced. This means the implied rate in valuing futures is higher. The strategy’s return will be significantly lower than typical returns on directional bets with futures. But directional bets have downside risk whereas the strategy to fade rates does not. Some compare the strategy with stable return investments such as bank deposits. The return on bank deposits can be higher for a longer maturity. But that comes with a penalty for breaking the deposit before maturity. In other words, strategy for fading rates cannot be meaningfully compared to a directional bet or to a stable income investment.
That said, you need a reference point to decide whether to engage in the strategy. To do this, the premise is that you will typically engage in directional bets with futures. When you occasionally observe an opportunity to fade rates, you must determine whether the strategy is economically meaningful. Suppose you need to break a bank deposit or move money from your savings account to fund the strategy. You must determine the opportunity cost of the decision. In the case of deposits, this would be the penalty for breaking the deposit and the loss of income for the period fading-the-rate strategy is open. Incorporate this cost as interest rate into the futures valuation model to see if the actual futures price is more than the theoretical price. You should initiate the strategy only if the theoretical futures price incorporating your opportunity cost is lower than the actual price.
Optional reading
The deposit used to fund the strategy must not be earmarked for any goal. Also, it would not be optimal to transfer money from equity investments earmarked for a goal to your trading portfolio. It must be a deposit created out of surplus cash or money in your savings account. Otherwise, the opportunity-cost principle used to determine if the traded futures is overpriced may not hold.
(The author offers training programmes for individuals to manage their personal investments)
Published on February 7, 2026
