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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.
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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
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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
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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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