No Arbitrage

No arbitrage is a fundamental principle that states there should be no risk free profit opportunities in efficient markets. If a risk free profit exists, traders will exploit it, which forces prices back into alignment.

Applications

• Pricing of options and derivatives.
• Forward and futures pricing relationships.
• Interest rate parity and currency pricing.

Example

If a stock and its futures price imply a risk free profit after adjusting for carry costs, arbitrageurs will trade until the pricing relationship is restored.

Practical notes

Real markets include transaction costs, funding limits, and execution risk, so small arbitrage gaps can persist.

Practical checklist

• Define the time horizon for No Arbitrage and the market context.
• Identify the data inputs you trust, such as price, volume, or schedule dates.
• Write a clear entry and exit rule before committing capital.
• Size the position so a single error does not damage the account.
• Document the result to improve repeatability.

Common pitfalls

• Treating No Arbitrage as a standalone signal instead of context.
• Ignoring liquidity, spreads, and execution friction.
• Using a rule on a different timeframe than it was designed for.
• Overfitting a small sample of past examples.
• Assuming the same behavior in abnormal volatility.

Data and measurement

Good analysis starts with consistent data. For No Arbitrage, confirm the data source, the time zone, and the sampling frequency. If the concept depends on settlement or schedule dates, align the calendar with the exchange rules. If it depends on price action, consider using adjusted data to handle corporate actions.

Risk management notes

Risk control is essential when applying No Arbitrage. Define the maximum loss per trade, the total exposure across related positions, and the conditions that invalidate the idea. A plan for fast exits is useful when markets move sharply.

Variations and related terms

Many traders use No Arbitrage alongside broader concepts such as trend analysis, volatility regimes, and liquidity conditions. Similar tools may exist with different names or slightly different definitions, so clear documentation prevents confusion.

Practical checklist

• Define the time horizon for No Arbitrage and the market context.
• Identify the data inputs you trust, such as price, volume, or schedule dates.
• Write a clear entry and exit rule before committing capital.
• Size the position so a single error does not damage the account.
• Document the result to improve repeatability.

Common pitfalls

• Treating No Arbitrage as a standalone signal instead of context.
• Ignoring liquidity, spreads, and execution friction.
• Using a rule on a different timeframe than it was designed for.
• Overfitting a small sample of past examples.
• Assuming the same behavior in abnormal volatility.

Data and measurement

Good analysis starts with consistent data. For No Arbitrage, confirm the data source, the time zone, and the sampling frequency. If the concept depends on settlement or schedule dates, align the calendar with the exchange rules. If it depends on price action, consider using adjusted data to handle corporate actions.

Risk management notes

Risk control is essential when applying No Arbitrage. Define the maximum loss per trade, the total exposure across related positions, and the conditions that invalidate the idea. A plan for fast exits is useful when markets move sharply.

Variations and related terms

Many traders use No Arbitrage alongside broader concepts such as trend analysis, volatility regimes, and liquidity conditions. Similar tools may exist with different names or slightly different definitions, so clear documentation prevents confusion.

Practical checklist

• Define the time horizon for No Arbitrage and the market context.
• Identify the data inputs you trust, such as price, volume, or schedule dates.
• Write a clear entry and exit rule before committing capital.
• Size the position so a single error does not damage the account.
• Document the result to improve repeatability.

Common pitfalls

• Treating No Arbitrage as a standalone signal instead of context.
• Ignoring liquidity, spreads, and execution friction.
• Using a rule on a different timeframe than it was designed for.
• Overfitting a small sample of past examples.
• Assuming the same behavior in abnormal volatility.

Data and measurement

Good analysis starts with consistent data. For No Arbitrage, confirm the data source, the time zone, and the sampling frequency. If the concept depends on settlement or schedule dates, align the calendar with the exchange rules. If it depends on price action, consider using adjusted data to handle corporate actions.

Risk management notes

Risk control is essential when applying No Arbitrage. Define the maximum loss per trade, the total exposure across related positions, and the conditions that invalidate the idea. A plan for fast exits is useful when markets move sharply.