Options Arbitrage - Definition
The use of stock options to reap marginal risk-free profit by locking value created through price differential between exchanges or
violation of Put Call Parity.
Options Arbitrage - Introduction
So, you wish to make money with NO RISK and CERTAINTY OF PROFIT in options trading?
Enters Options Arbitrage!
What exactly is arbitrage? Arbitrage is the opportunity to make risk-free profit by simultaneously buying an underpriced asset and selling
it at market price.
Arbitrage has been regarded as the "holy grail" of the capital markets and options arbitrage certainly is the holy grail of free profits for the
privileged options traders in options trading.
Arbitrage in stock trading typically makes use of price differential of the same security between international
markets. Options arbitrage, however, has a lot more opportunities than stock arbitrage as one could not only make use of price differential
between exchanges but also violations in
Put Call Parity between
stock options. In fact,
have also been created to take advantage of specific options arbitrage opportunities and we shall be exploring
some of these options arbitrage strategies in this tutorial.
Be warned that this truly
is advanced, complex options trading knowledge and not recommended for beginner options traders.
drawback of options arbitrage is that profitable opportunities are hard to come by and gets filled out extremely fast by computers used by big
financial institutions that are monitoring for such opportunities at all times. Even if a profitable opportunity is discovered, the commissions
involved in such complex options arbitrage strategies usually takes all the profits away. That is why options arbitrage is commonly the
realm of professional options traders who need not pay broker fees such as
Market Makers and floor traders. Even for obvious options arbitrage opportunities, each position must be experted performed by legging into each side of the trade at the best possible prices in order to guarantee the profitability of the positions.
How Does Options Arbitrage Work?
For arbitrage to work, an inequality in price of the same security must exist. When a security is underpriced in another market, you simply
buy the underpriced security in that market and then sell it at the market price in this market simultaneously in order to reap a risk-free
profit. That is the same concept in options arbitrage with the only difference being in the definition of the term "underpriced". "Underpriced" takes
on a much wider spectrum of meaning in options trading. A
call option can be underpriced in regards to another call option of the same
underlying stock, that call option can also be underpriced in regards to a
put option and options of one
expiration can also be underpriced
in regards to options of another expiration. All these are governed by the principle of Put Call Parity. When Put Call Parity is violated,
options arbitrage opportunities exist.
Because options arbitrage work on the basis of differences in the relative value of one option against another,
it is known as "relative value arbitrage". Rather than simply buying and selling securities simultaneously in order to perform an arbitrage
trade as in stock arbitrage, options arbitrage makes use of complex spread strategies to "lock in" the arbitrage value and typically wait for the
spread to unwind by expiration before reaping the full reward.
There are 5 main methodologies for options arbitrage; Strike Options Arbitrage (or Strike Arbitrage), Calendar Options Arbitrage (or Calendar
Arbitrage), Intra-market Options Arbitrage (or Intra-market Arbitrage), Conversion / Reversal and Box.
Options Arbitrage Strategies
Box Arbitrage -
Box arbitrage or Box conversion, is an options arbitrage strategy taking advantage of discrepancies across both call and put options of different
strike prices by "boxing in" the profit using a 4 legged spread. This is also known as a
Conversion & Reversal Arbitrage -
Conversion and Reversal arbitrage works when a price difference between the stock and its
synthetic equivalent exists. By selling the underpriced of
the two and then simultaneously buying the overpriced, risk-free profit can be obtained.
Learn all about
Conversion & Reversal Arbitrage.
Calendar Arbitrage -
Calendar Arbitrage takes advantage of abnormally higher extrinsic value of nearer term options than longer term options through simultaneously
selling the nearer term option and buying the longer term option of the same strike price. Such conditions are
extremely rare as longer term options typically have much higher extrinsic value than nearer term options.
Dividend Arbitrage -
Dividend Arbitrage makes use of lower cost of hedging in order to lock in a higher dividend gain risk-free.
Learn all about
Intra-market Arbitrage -
Intra-market arbitrage is exactly what stock traders do for stock arbitrages. It is where the same option is sold for slightly different prices
in different exchanges. The cheaper option is then bought while simultaneously selling it at the exchange where it is more expensive.
Strike Arbitrage -
Strike Arbitrage takes advantage of abnormally high
extrinsic value through simultaneously buying and selling options of the same
underlying stock and expiration but at different
strike prices. When the difference in extrinsic value yield exceeds the difference in
strike prices, a risk-free options arbitrage trade is formed. Learn all about
Advantages of Options Arbitrage
Able to obtain risk-free profits.
Disadvantages of Options Arbitrage
Options arbitrage opportunities are extremely hard to spot as price discrepancies are filled very quickly.
High broker commissions makes options arbitrage difficult or plain impossible for amateur traderr.
Important Disclaimer :
Options involve risk and are not suitable for all investors.
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