Options arbitrage offers traders a way to profit from market inefficiencies with minimal risk. But how do arbitrage option trading strategies actually work? This article deals with key options arbitrage strategies, including classic methods and box spreads, revealing how they capitalize on pricing gaps, interest rates, and dividends to secure returns.
Key takeaways
- Options arbitrage is a strategy where traders capitalize on pricing inefficiencies by simultaneously buying and selling related options contracts within the same market. While it can offer low-risk profits, execution costs and capital requirements often make it impractical for retail traders.
- With classic arbitrage option trading strategies, you can take advantage of market inefficiencies, like small price differences at the strike level.
- There are other “arbitrage” strategies, like box spreads, which can give a profit derived from interest rates and dividends rather than from hard-to-find market inefficiencies.
What Is Options Arbitrage?
Options arbitrage is a strategy where traders exploit pricing inefficiencies within the same market by simultaneously buying and selling related options contracts to capture risk-free or low-risk profits. These opportunities rely on pricing inefficiencies in the options market and can lead to predictable, low-risk returns.
Why does this work? Factors like volatility, liquidity, and mismatched pricing play a huge role. When market conditions fluctuate, some options might be priced incorrectly, creating openings for traders to apply arbitrage option trading strategies.
Here’s why options arbitrage is considered low-risk:
- It doesn’t depend on market direction. Whether the market goes up or down, the structure of options arbitrage ensures a profit as long as the price gap exists.
- Profits are locked in since you’re exploiting guaranteed price differences, not speculating on future trends.
A simple example helps illustrate this. Imagine an option on Stock XYZ is priced at $10 in one market and $12 in another. By simultaneously buying the cheaper option at $10 and selling it at $12, you secure a $2 profit per contract, no matter how the stock moves. Obviously, this is an extra simplification. As you can guess, options arbitrage is much harder in real life and comes with lower profit margins (otherwise, everyone would do it!).
Key Benefits of Options Arbitrage Strategies
Here are a couple of straightforward benefits coming from options arbitrage strategies:
- They allow traders to capitalize on market quirks without significant risk.
- They emphasize precision rather than guesswork, making them appealing for low-risk trading.
However, these opportunities are rare and often short-lived. Identifying arbitrage opportunities requires understanding market movements and acting quickly to exploit them. For traders who do, these strategies can offer steady, predictable returns.
The Importance of the Put-Call Parity for Options Arbitrage
It’s impossible to understand options arbitrage without taking into account the put-call parity principle.
Put-call parity states that the price of a call option combined with the strike price (discounted to the present value) should equal the price of a put option plus the underlying asset’s current price. This relationship hinges on factors like the strike price, the time until expiration, and market interest rates. If prices fall out of sync, arbitrage option trading strategies step in to exploit the gap.
This concept defines the relationship between call options, put options, and their underlying asset, ensuring balanced pricing. When this balance—put-call parity—is maintained, no arbitrage opportunities exist. But when it’s disrupted, traders can take advantage.
Example of a Put-Call Parity Violation
Suppose a call option for Stock ABC is priced at $5, while the equivalent put option costs $8. If the current stock price and strike price calculations don’t align with put-call parity, you can buy the underpriced call, sell an overpriced put, and lock in a risk-free profit. While we won’t give you the math involved in the process here, you can find more details on the put-call parity principle by reading our article on the topic (we’ll put a link at the bottom of this article).
Why It Matters for Options Arbitrage
- Identifying Arbitrage Opportunities: Traders look for pricing mismatches to set up risk-free trades.
- Precision Is Key: Accurate pricing models and tools are critical for spotting these fleeting opportunities.
- Risks to Consider: Market inefficiencies aren’t the sole factor; events like sudden volatility or low liquidity can throw off parity assumptions.
Put-call parity is central to options arbitrage strategies, but overreliance on it may mislead traders. Constant market monitoring is essential to manage the risks and make the most of pricing gaps when they appear.
A Classic Options Arbitrage Strategy
The classic textbook example of options arbitrage is, without a doubt, the strategy that relies on the concept of strike prices. Strike arbitrage – as we will call it from now on – is a method for profiting from price differences between two options contracts. These contracts share the same underlying asset and expiration date but differ in their strike prices.
Strike arbitrage takes advantage of situations where the gap between strike prices is smaller than the gap in their extrinsic values. By buying one option and selling (writing) another, traders can theoretically secure a profit that doesn’t depend on market direction.
Example of Strike Arbitrage
Consider this situation:
- Stock ABC is trading at $50.
- A call option with a $50 strike price costs $2, while a call option with a $48 strike price costs $5.
- The first option is entirely extrinsic value ($2). The second option is $2 in-the-money, so its extrinsic value is $3.
- The extrinsic value difference is $1, but the strike price difference is $2.
How can you profit in this scenario? Here’s an idea:
- Buy the $50 call for $2 and sell the $48 call for $5. This gives a $3 net credit.
- If the stock moves below $48, both options expire worthless, and you keep the $3.
- If the stock stays at $50, the liability on the sold option equals $2, leaving $1 profit.
- If the stock rises above $50, gains from the purchased option offset losses from the sold one, maintaining the $3 credit.
In short, we have this situation:
| Scenario | Outcome | Net Result |
| Stock moves below $48 | Both options expire worthless, and you keep the $3 net credit. | $3 profit |
| Stock stays at $50 | Liability on the sold option equals $2, leaving $1 profit. | $1 profit |
| Stock rises above $50 | Gains from the purchased option offset losses from the sold option, maintaining the $3 credit. | $3 credit retained |
While strike arbitrage guarantees a profit, such opportunities are rare, offering slim margins (unlike the example above). Consequently, traders often find them impractical for regular use in options arbitrage strategies.
In general, we do not think that retail traders can make a significant profit from the use of the put-call parity principle or from a strike arbitrage. There are, however, different ways in which you can achieve a profit with a sort of “arbitrage” strategy that relies on interest rates or dividends, rather than on hard-to-find market inefficiencies.
Box Spread
If we go beyond the classic strategy mentioned above, there are more ways to use the arbitrage principle. One standout method is the box spread, which acts as a “proxy” options arbitrage strategy (in line with what we told you at the end of the section above).
A box spread combines a bull call spread and a bear put spread, both sharing the same strike prices and expiration dates. Here’s how to construct it through our screener for options trades:
- Buy an in-the-money (ITM) call option
- Sell an out-of-the-money (OTM) call option
- Buy an ITM put option
- Sell an OTM put option
Your profit and loss profile will generally look like this (notice that the yellow lines correspond to your bull call spread position, the red line indicates the bear put spread trade, and the white line is your overall profit):
This setup exploits the difference between the trade’s cost and the fixed payoff at expiration. If the total setup cost is lower than the strike price difference, the strategy locks in a near risk-free return.
Despite their low-risk nature, box spreads have limitations. Transaction fees and market slippage can eat into profits, making the strategy less practical for smaller trades. While reliable, options arbitrage strategies like this demand careful planning to make them worthwhile for traders looking to optimize returns.
Example of Box Spread
For example, with SPY trading at $584.59, constructing a box spread involves calculating premium costs, strike price differences, and potential payouts. In this case, the strategy results in a potential profit of $10 (before commissions) with a total cost of $990 and a maximum payout of $1,000. For a step-by-step breakdown of this example, check out our dedicated article on the box spread strategy.
Conversion/Reversal Arbitrage
Another “proxy” strategy for options arbitrage involves exploiting price discrepancies between a position and its synthetic equivalent. This approach leverages inconsistencies in put-call parity to secure risk-free profits.
Example of Conversion/Reversal Arbitrage
For example, imagine creating a synthetic long call by buying stock and purchasing a put option. If the cost of this synthetic position is lower than the price of an actual call option, you could buy the synthetic and sell the call for guaranteed profit.
- Conversion: Buying stock to create a synthetic equivalent.
- Reversal: Short selling stock in the setup.
These arbitrage option trading strategies and opportunities are rare but effective when spotted.
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