Arbitrage Option Trading Strategy is a way of earning small profits without any risk. Traders make a profit by selling the same asset in different markets where its price is a bit high.
In simple words, a trader purchases an asset in the market where its price is low and then sells the same asset in a different market where the buyer is willing to pay more for it.
About Arbitrage Option Trading Strategy
Arbitrage defines a situation where it’s possible to earn small profits by making numerous trades on a single asset without any risk of loss due to differences in costs.
For example, an asset is trading in one market for INR 250 and the same asset is trading in the other market for INR 300, at the same time.
If the trader buys an asset at INR 250, he can easily sell it in another market for INR 300. This is how people make profits without any involvement of risk.
As a matter of fact, arbitrage trading is a bit more complex than it seems. The example above provides a piece of basic knowledge about its concept. In options arbitrage trading, opportunities occur when the options have lesser pricing than the market price.
Arbitrage trading sounds great but unfortunately, the opportunities are extremely less for the common man because when they occur, the powerful computers of big organizations detect them before any normal trader could.
One cannot earn major profits from this therefore, it is not much advisable. However, put-call parity leads to many arbitrage opportunities.
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Put-Call Parity and Arbitrage Opportunities
The put-call parity’s principle was discovered by Hans Stoll in 1969. For arbitrage to work successfully, there should be a great difference in the cost of security. Put-call parity explains the link between calls, puts, and the underlying futures contract.
In the example above, we see that security has a lesser price. We can implement the term “low price” in various scenarios, actually.
For instance, a call is under-priced at INR 250, in comparison to a put having the same security which is priced at INR 300 or it can be under-priced at INR 250 in comparison to a different call which is priced at INR 350, having a different date of expiration. Theoretically, under-pricing is not expected to take place due to the concept of put-call parity.
If we follow put-call parity, arbitrage opportunities do not exist. When we violate the put-call parity, an arbitrage opportunity exists.
In such cases, traders have the option to use various strategies to generate returns with no involvement of risk. We have discussed a few of these strategies here.
Strike Arbitrage, a type of Options Arbitrage Strategy, works to make a profit if in case a price difference occurs between two contracts that have similar underlying security, and same date of expiration but dissimilar strikes.
The plot where this approach can be widely applied is when the discrepancy between the two strikes is a bit less than their actual values.
Example of Strike Arbitrage Strategy
For instance, a company XYZ is trading its stock at INR 1000, and a call having its strike of INR 1000 exists which costs INR 100.
Another call having its strike of INR 950 exists which costs INR 300. So, the first call’s extrinsic value is the entire price, that is, INR 100 whereas the second one has the extrinsic value of INR 300- INR 100, that is, INR 200.
The discrepancy between the value of both these options is INR 100 whereas the discrepancy between these strikes is INR 50.
This means that the arbitrage opportunity exists. The advantage, in this case, happens is when the trader buys the first call at INR 100 and sells it at INR 300.
More About Strike Arbitrage Options Trading Strategy
By doing this, we earn a credit of INR 200 on each contract purchased which would eventually lead to great profits.
If the amount of the company XYZ’s stock dropped to INR 900, the contracts purchased and written would become worthless. The total credit, in that case, would be the surplus.
If the company’s stock remained the same, that is, INR 1000, the options which they purchased will expire.
It will become worthless whereas the ones written would sustain a great liability of INR 100 per contract and that would eventually lead to a surplus or profit.
If the cost of company XYZ’s stock rises above INR 1000, then additional liabilities, if any, of these written options would be nullified by the surplus amount produced from the one’s written.
From this, it is observed that this strategy has the ability to give back profits regardless of what resulted in the cost of the underlying security.
Strike arbitrage has the potential to take place in various different ways, as well when there is a cost difference between two options which are of a similar kind having different strikes.
Such opportunities for discrepancies to exist are very rare. Even if it does, there will be very few margins for profits.
Conversion and Reversal Arbitrage
Conversion and Reversal Arbitrage is a category of an options arbitrage strategy. It returns a risk-free profit.
To understand the concept of Conversion and Reversal arbitrage, one needs to have a good knowledge of trading strategies.
He needs to know more about synthetic positions and synthetic options. This is because they are the key aspects of conversion and reversal arbitrage.
Conversion and reversal arbitrage strategies use synthetic positions to take supremacy of variability in put-call parity. It’s possible for price differences between a known position and their synthetic position to arise.
When it arises, the trader can buy cheaper positions. Now, he can sell the one having a greater price for a confirming and riskless return.
Example of Conversion & Reversal Arbitrage Option Trading Strategy
For instance, XYZ company’s shares are trading at INR 5000 and its April INR 5000 call is trading at INR 250 and its April INR 5000 put is trading at INR 150. The extrinsic value of the synthetic short stock will be INR 100 Credit (INR 250- INR 150).
There is an INR 100 difference in extrinsic value between Synthetic Short Stock and actual Short Stock. This means that conversion arbitrage is possible. If buying stock tangles in a particular part of this strategy, which means the conversion is possible.
If short selling stock happens to be present in any part of the strategy, it is what we call a reversal. The occasion to make use of conversion and reversal arbitrage are extremely less so it’s not worth spending excessive time and effort on.
But, if someone is lucky enough to spot a circumstance where differences occur between the cost for making a position & the cost for creating its synthetic position, in that case, conversion & reversal arbitrage has its actual advantages.
Box spread, which is a type of an options trading strategy, involves a total of four different transactions. Now, the box spreads are almost riskless.
They capitalize on bull calls and bear put spreads. The profit here in this is the difference between the total cost of options and the difference between strike prices.
We use it to determine the expiration value of option spreads.
Example of Box Spread
For example, if a company XYZ is trading each share at INR 2500, in order to execute a box spread, the investor has to purchase in-the-money (ITM) call and put and then sell out-of-the-money (OTM) call and put.
Now, if the company purchases 100 ITM calls for INR 6500 debit and 200 puts for INR 6000 debit and sells 200 OTM calls for INR 1500 credits and 100 OTM puts for INR 1500 credits, the total cost for the trader for “call spread” will be (INR 6500- INR 1500) INR 5000 and that for the put spread will be (INR 6000- INR 1500) INR 4500.
So, the total cost of the box spread for the investor will be (INR 5000+ INR 4500) INR 9500.
The strike price spread is the difference between the highest and lowest prices of the strike. Considering the example above, the spread would be 20 – 10, that is, 10. There are four legs to the spread box.
Assuming that each “options contract” contains 100 shares, the total expiry value of the “box spread” will be 100 x 100, that is, INR 10000.
The profit, in this case, will be (INR 10000 – INR 9500) INR 500. However, there are very few chances to identify an occasion to utilize box spread.
Arbitrage Option Trading Strategy – Conclusion
Overall, spending much time on arbitrage trading is not worth it because the opportunity is very less and infrequent. The profit edge is very less even after applying serious efforts.
Sometimes, we see emerging opportunities but the businesses and teams with better equipment bag them away.
Having basic knowledge about it is not harmful though, since it can help in grabbing opportunities, if available.
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