Options Arbitrage Strategies

Options arbitrage strategies are trading techniques that exploit price inefficiencies between related securities in options markets to generate risk-free profits. These strategies are a type of advanced trading strategy typically used by professional traders and hedge funds. Options themselves are financial instruments that derive value from an underlying asset, such as stocks, indices, or commodities. Below, we will explore the most popular types of options arbitrage strategies, along with examples and explanations of how they work.

1. Definition and Overview

Options arbitrage involves entering multiple simultaneous trades to take advantage of price discrepancies in the options market. The overall goal is to lock in a profit without assuming any directional risk on the underlying security. This might involve trading options on the same underlying asset but with different strike prices, expiration dates, or in different markets.

2. Types of Options Arbitrage Strategies

2.1. Conversion Arbitrage

Conversion arbitrage involves the creation of a synthetic long position in the underlying asset. This position is created by purchasing a call option and selling a put option, while simultaneously shorting the underlying asset (or holding a short position).

Steps:

  1. Buy a call option.
  2. Sell a put option (both with the same strike price and expiration date).
  3. Short the underlying asset (or keep the short position open).

Example: Assume Stock XYZ is trading at $100. You could buy a call option with a strike price of $100 for a premium of $5, sell a put option with the same strike price for a premium of $5, and short the stock at $100. The positions effectively cancel out market risk, locking in the premiums collected.

2.2. Reverse Conversion Arbitrage

The reverse conversion arbitrage strategy is essentially the opposite of conversion arbitrage. It involves the creation of a synthetic short position in the underlying asset. This position is created by selling a call option, buying a put option, while simultaneously holding a long position in the underlying asset.

Steps:

  1. Sell a call option.
  2. Buy a put option (both with the same strike price and expiration date).
  3. Long the underlying asset (or hold an equivalent long position).

Example: Assume Stock XYZ is trading at $100. You sell a call option with a strike price of $100 for a premium of $5, buy a put option with the same strike price for a premium of $5, and hold the stock at $100. Similar to conversion arbitrage, this strategy locks in the collected premiums.

2.3. Box Spread

A box spread arbitrage strategy is a more sophisticated approach. It involves establishing a combination of a bull call spread and a bear put spread, creating a risk-free position if executed correctly.

Steps:

  1. Buy a call option and sell another call option with a higher strike price (Bull Call Spread).
  2. Buy a put option and sell another put option with a higher strike price (Bear Put Spread).
  3. Ensure all options have the same expiration dates.

Example: Consider Stock XYZ:

The goal is to exploit mispriced options to gain riskless profit, adjusting the combinations to lock in a guaranteed profit made from discrepancies.

2.4. Butterfly Spread Arbitrage

Butterfly spread arbitrage involves creating a position that has no risk and minimal cost with the aim of capturing a guaranteed profit if prices converge to estimated levels.

Steps:

  1. Buy one “in-the-money” call option.
  2. Sell two at-the-money call options.
  3. Buy one “out-of-the-money” call option.

Example: For Stock XYZ at $100:

If the trade setup is executed at a net zero cost or a small credit, any contraction in implied volatility or time decay will ensure profit.

3. Why Options Arbitrage Exists

Options arbitrage exists due to inefficiencies in the markets. Such inefficiencies can be caused by a variety of factors including:

4. Risks Involved

While options arbitrage might sound risk-free theoretically, practical risks do exist:

5. Tools and Platforms

Professional traders use advanced tools and platforms to automate and manage these strategies. Some prominent platforms include:

6. Conclusion

Options arbitrage strategies are a sophisticated, nuanced approach to trading that leverage market inefficiencies to secure riskless profits. While theoretically straightforward, effective implementation requires robust tools, quick execution, and deep market knowledge. As with any financial strategy, understanding the intricacies and potential pitfalls is crucial for success.