Strike Arbitrage

How Does The Strike Arbitrage Work in Options Trading?

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Strike Arbitrage - Definition

Strike Arbitrage is an options arbitrage strategy which takes advantage of discrepancies in extrinsic value across 2 different strike prices on the same stock in order to make a risk-free profit.

Strike Arbitrage - Introduction

You need a comprehensive knowledge of options arbitrage before you can fully understand Strike Arbitrage.

Strike arbitrage takes advantage of dramatic breaches in Put Call Parity resulting in large surges in the extrinsic value of stock options of certain strike prices. This situation occurs mainly in out of the money options when sudden demand surges causes implied volatility to move temporarily out of proportion. To put simply, when the price of out of the money options are higher than in the money options, a possible Strike Arbitrage opportunity may arise. Such opportunities are extremely rare, gets filled out and corrected quickly and may not result in enough profits to justify the commissions paid. That is why strike arbitrage remains the domain of professional options traders such as floor traders and market makers who need not pay broker commissions.

How Does Strike Arbitrage Work?

When the options market is in a state of Put Call Parity, the difference in extrinsic value between 2 options of the same expiration date and underlying stock should not exceed the difference in their strike prices and that out of the money options should be cheaper in than in the money options. The difference in the extrinsic value between a March $50 Call option and a March $55 Call option should not exceed $5 and that the March $55 call option should be cheaper than the March $50 Call options. This is why when you buy the March $50 Call Option and sell the March $55 call option, you get a Bull Call Spread which profits only when the stock goes up and loses money when the stock goes down.

However, there are times when put call parity is violated to the extend that the difference in extrinsic value between 2 strike prices exceeds the difference in the strike price itself and that out of the money options actually becomes more expensive than in the money options. When that happens, you can perform a Strike Arbitrage to lock in that abnormally high extrinsic value by buying the undervalued in the money option and selling the overvalued out of the money option. That is the same as putting on a Bull Call Spread except that instead of paying a debit for it, you actually get a net credit.

If the stock remains stagnant by expiration of the strike arbitrage, the extrinsic value of both options erode away earning you the difference in extrinsic value as profit.

If the stock rallies above the higher strike price by expiration of the strike arbitrage, the extrinsic values erode away while the closing value of the position remains as the difference between both strike prices. The strike arbitrage then makes the difference between the strike prices and the net premium yield as profit.

If the stock drops below the lower strike price by expiration of the strike arbitrage, the position becomes zero as the extrinsic values erode away along with the intrinsic value of the in the money option. You then make the net credit as profit. As such, the Strike Arbitrage is a completely risk-free options strategy.

When To Use Strike Arbitrage?

When the difference in extrinsic value between 2 options of the same stock and expiration exceeds the difference in their strike price.

Strike Arbitrage Example Assuming XYZ company's shares are trading at $51 and its March $50 Call is trading at $1.50 and its March $52 Call is trading at $3.00. Difference in extrinsic value = $3.00 - ($1.50 - $1.00) = $2.50 Difference in strike price = $52 - $50 = $2.00 The difference in extrinsic value exceeds the difference in strike price, therefore, strike arbitrage is possible.

How To Establish Strike Arbitrage?

Simply Buy the In the money option and sell an equal number of the out of the money option.

Strike Arbitrage Example Assuming XYZ company's shares are trading at $51 and its March $50 Call is trading at $1.50 and its March $52 Call is trading at $3.00. Buy to open March $50 Call and Sell to open March $55 Call. Net Credit = $3.00 - $1.50 = $1.50

Profit Potential Of Strike Arbitrage

A properly executed strike arbitrage has zero chance of a loss with maximum profit occuring when the stock stay totally stagnant.

Profit Calculation of Strike Arbitrage :

Minimum Profit = Net Extrinsic Value - Difference In Strike
(When stock rises above higher strike price)

Maximum Profit = Net Extrinsic Value
(When stock remains totally stagnant)

Following up from the above strike arbitrage example: Minimum Profit = $2.50 - $2.00 = $0.50 Maximum Profit = $2.50

Risk / Reward of Protective Puts:

Upside Maximum Profit: Limited

Maximum Loss: No Loss Possible

Advantages of Strike Arbitrage

Able to obtain risk-free profits.

Disadvantages of Strike Arbitrage

Strike Arbitrage opportunities are extremely hard to spot as price discrepancies are filled very quickly.

High broker commissions makes Strike Arbitrage difficult or plain impossible for amateur trader.

Resulting credit spread position means that traders with low trading level may not be able to put on such a position.

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