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Options Arbitrage

What is Options Arbitrage in Options Trading?

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, options strategies 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.

OppiE's NoteBe warned that this truly is advanced, complex options trading knowledge and not recommended for beginner options traders.

The only 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 Box Spread.

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 Dividend Arbitrage.

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 Strike Arbitrage.

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 trader.
  • cool feature! Can't Decide Which Options Strategy To Use? Try our Option Strategy Selector!

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