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Glossary

Options arbitrage: Explained

BY TIO Staff

|August 12, 2024

Options arbitrage is a complex yet intriguing aspect of trading that involves the simultaneous buying and selling of options to take advantage of price discrepancies. This strategy is typically employed by professional traders and hedge funds, and it requires a deep understanding of the options market, as well as the ability to identify and act on arbitrage opportunities quickly. In this comprehensive glossary entry, we will delve into the intricate world of options arbitrage, breaking down its key concepts, strategies, and implications.

While options arbitrage may seem like a daunting topic, it is crucial to understand that it is simply a manifestation of the fundamental economic principle of no free lunch. In other words, the opportunities for risk-free profits that options arbitrage presents are fleeting and are quickly eliminated by the actions of arbitrageurs. Therefore, successful options arbitrage requires not only a solid grasp of the underlying theory but also the ability to act swiftly and decisively.

Understanding Options

Before we delve into the specifics of options arbitrage, it is crucial to understand what options are. Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price, known as the strike price, before a certain date. There are two types of options: call options, which give the holder the right to buy, and put options, which give the holder the right to sell.

Options are used for a variety of purposes, including hedging, speculation, and income generation. However, in the context of options arbitrage, they are primarily used as a tool to exploit price discrepancies in the market. The price of an option is determined by a number of factors, including the price of the underlying asset, the strike price, the time to expiration, the risk-free interest rate, and the volatility of the underlying asset.

Call Options

A call option gives the holder the right to buy an underlying asset at a predetermined price before a certain date. The buyer of a call option expects the price of the underlying asset to rise, while the seller expects it to fall. The price of a call option is influenced by several factors, including the price of the underlying asset, the strike price, the time to expiration, the risk-free interest rate, and the volatility of the underlying asset.

For example, if a trader buys a call option on a stock with a strike price of $50, and the stock's price rises to $60, the trader can exercise the option to buy the stock at $50 and then sell it at the market price of $60, making a profit of $10 per share. However, if the stock's price falls below $50, the trader will not exercise the option, and the maximum loss will be the premium paid for the option.

Put Options

A put option, on the other hand, gives the holder the right to sell an underlying asset at a predetermined price before a certain date. The buyer of a put option expects the price of the underlying asset to fall, while the seller expects it to rise. Like call options, the price of a put option is influenced by several factors, including the price of the underlying asset, the strike price, the time to expiration, the risk-free interest rate, and the volatility of the underlying asset.

For instance, if a trader buys a put option on a stock with a strike price of $50, and the stock's price falls to $40, the trader can exercise the option to sell the stock at $50 and then buy it back at the market price of $40, making a profit of $10 per share. However, if the stock's price rises above $50, the trader will not exercise the option, and the maximum loss will be the premium paid for the option.

Understanding Arbitrage

Arbitrage is a trading strategy that involves the simultaneous buying and selling of securities to take advantage of price discrepancies. The goal of arbitrage is to make a risk-free profit, meaning that the trader is guaranteed to make a profit regardless of the direction of the market. Arbitrage opportunities arise due to factors such as market inefficiencies, differences in interest rates, and discrepancies in exchange rates.

In the context of options, arbitrage involves the simultaneous buying and selling of options or the combination of options and their underlying assets to exploit price discrepancies. Options arbitrage strategies are typically complex and require a deep understanding of the options market, as well as the ability to identify and act on arbitrage opportunities quickly.

Types of Arbitrage

There are several types of arbitrage, each with its own set of strategies and risks. The most common types of arbitrage include risk arbitrage, statistical arbitrage, and triangular arbitrage. Risk arbitrage involves taking advantage of price discrepancies between securities that are related in some way, such as stocks and their derivatives. Statistical arbitrage involves using mathematical models to identify price discrepancies, while triangular arbitrage involves taking advantage of price discrepancies between three different currencies.

In the context of options, the most common types of arbitrage are options arbitrage, volatility arbitrage, and convertible arbitrage. Options arbitrage involves exploiting price discrepancies between options and their underlying assets, while volatility arbitrage involves exploiting discrepancies between the implied volatility of options and the expected volatility of their underlying assets. Convertible arbitrage involves exploiting price discrepancies between convertible securities and their underlying assets.

Options Arbitrage Strategies

There are several strategies that traders can use to exploit options arbitrage opportunities. These strategies typically involve the simultaneous buying and selling of options or the combination of options and their underlying assets. The most common options arbitrage strategies include the box spread, the conversion, the reversal, and the butterfly spread.

Each of these strategies has its own set of risks and rewards, and they require a deep understanding of the options market to execute effectively. Furthermore, these strategies are typically employed by professional traders and hedge funds, as they require significant capital and the ability to act quickly on arbitrage opportunities.

Box Spread

The box spread is an options arbitrage strategy that involves buying a bull call spread and a bear put spread with the same strike prices and expiration dates. The goal of the box spread is to create a risk-free position that will result in a guaranteed profit regardless of the direction of the market. The profit from the box spread is the difference between the premiums received from selling the spreads and the premiums paid for buying the spreads.

However, the box spread is not without its risks. The main risk of the box spread is execution risk, which is the risk that the trader will not be able to execute all four legs of the spread at the desired prices. Furthermore, the box spread requires significant capital and the ability to act quickly on arbitrage opportunities, making it a strategy that is typically employed by professional traders and hedge funds.

Conversion and Reversal

The conversion and reversal are two related options arbitrage strategies that involve the combination of options and their underlying assets. The conversion involves buying a stock, buying a put option on the stock, and selling a call option on the stock with the same strike price and expiration date. The goal of the conversion is to create a risk-free position that will result in a guaranteed profit regardless of the direction of the market.

The reversal, on the other hand, involves selling a stock, buying a call option on the stock, and selling a put option on the stock with the same strike price and expiration date. Like the conversion, the goal of the reversal is to create a risk-free position that will result in a guaranteed profit regardless of the direction of the market. However, both the conversion and the reversal require significant capital and the ability to act quickly on arbitrage opportunities, making them strategies that are typically employed by professional traders and hedge funds.

Implications of Options Arbitrage

Options arbitrage has several implications for the market and for traders. For the market, options arbitrage helps to ensure that prices are efficient, meaning that they reflect all available information. This is because arbitrageurs, by taking advantage of price discrepancies, help to eliminate these discrepancies and bring prices into line with their intrinsic values.

For traders, options arbitrage provides opportunities for risk-free profits. However, these opportunities are fleeting and require a deep understanding of the options market, as well as the ability to act quickly. Furthermore, options arbitrage strategies are typically complex and require significant capital, making them strategies that are typically employed by professional traders and hedge funds.

Market Efficiency

One of the main implications of options arbitrage is that it helps to ensure market efficiency. Market efficiency is the idea that prices reflect all available information, and it is a fundamental concept in finance. When prices are efficient, it means that there are no opportunities for risk-free profits, as any price discrepancies are quickly eliminated by the actions of arbitrageurs.

Options arbitrage plays a crucial role in ensuring market efficiency by eliminating price discrepancies between options and their underlying assets. When an arbitrageur identifies a price discrepancy, they will buy the underpriced security and sell the overpriced security, thereby bringing their prices into line with their intrinsic values. This process helps to ensure that prices are efficient and that they reflect all available information.

Risk and Reward

While options arbitrage provides opportunities for risk-free profits, it is not without its risks. The main risk of options arbitrage is execution risk, which is the risk that the trader will not be able to execute the arbitrage strategy at the desired prices. This risk is particularly significant in volatile markets, where prices can change rapidly.

Furthermore, options arbitrage strategies are typically complex and require a deep understanding of the options market. They also require significant capital and the ability to act quickly on arbitrage opportunities. Therefore, while options arbitrage can provide opportunities for risk-free profits, it is a strategy that is typically employed by professional traders and hedge funds, and it is not suitable for all investors.

Conclusion

Options arbitrage is a complex yet intriguing aspect of trading that involves the simultaneous buying and selling of options to take advantage of price discrepancies. While it provides opportunities for risk-free profits, it requires a deep understanding of the options market, as well as the ability to act quickly and decisively. Furthermore, options arbitrage strategies are typically complex and require significant capital, making them strategies that are typically employed by professional traders and hedge funds.

Despite its complexities, options arbitrage plays a crucial role in ensuring market efficiency by eliminating price discrepancies between options and their underlying assets. Therefore, whether you are a professional trader looking to exploit arbitrage opportunities or a curious observer seeking to understand the intricacies of the options market, understanding options arbitrage is a valuable part of your trading knowledge.

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TIO Staff

Behind every blog post lies the combined experience of the people working at TIOmarkets. We are a team of dedicated industry professionals and financial markets enthusiasts committed to providing you with trading education and financial markets commentary. Our goal is to help empower you with the knowledge you need to trade in the markets effectively.